11-05-11 black - the legal and institutional foundations for strong capital markets

8/6/2019 11-05-11 Black - The Legal and Institutional Foundations for Strong Capital Markets

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THE LEGAL AND INSTITUTIONAL PRECONDITIONSFOR STRONG SECURITIES MARKETS

Bernard S. Black*

An important challenge for all economies, at which only a few have suc-ceeded, is creating the preconditions for a strong market for common stocks andother securities. A strong securities market rests on a complex network of legaland market institutions that ensure that minority shareholders (1) receive goodinformation about the value of a companys business and (2) have confidencethat a companys managers and controlling shareholders wont cheat them out ofmost or all of the value of their investment. A country whose laws and relatedinstitutions fail on either count cannot develop a strong securities market, forcing

firms to rely on internal financing or bank financingboth of which have impor-tant shortcomings. In this Article, Professor Bernard Black explains why thesetwo investor protection issues are critical, related, and hard to solve. He dis-cusses which laws and institutions are most important for each, which of theselaws and institutions can be borrowed from countries with strong securities mar-kets, and which must be homegrown.

INTRODUCTION............................................................................................................. 782I. INFORMATION ASYMMETRY BARRIERS

TO SECURITIES OFFERINGS .................................................................................... 786A. Information Asymmetry and the Role

of Reputational Intermediaries ......................................................................786

B. The Core Institutions that ControlInformation Asymmetry ................................................................................ 789

C. Additional Useful and Specialized Institutions............................................. 7991. Useful Institutions.................................................................................. 799

* I thank the Organisation for Economic Co-operation and Development (OECD) for

financial support. I thank John Coffee, Rob Daines, David Ellerman, Ron Gilson, Jeff Gordon, PeterHenry, Steven Huddart, Cally Jordan, Ehud Kamar, Michael Klausner, Ross Levine, Amir Licht,William Megginson, Jamal Munshi, and participants in an OECD conference on CorporateGovernance in Asia, an International Monetary Fund workshop on Comparative CorporateGovernance in Developing and Transition Economies, the UCLA School of Law First AnnualCorporate Governance Conference, and workshops at the American Law & EconomicsAssociation, Brazil Securities Commission, Brazil Stock Exchange, Korean Securities LawAssociation, Seoul National University School of Business, Stanford Law School, University ofMissouri-Columbia Law School, and University of Sao Paolo Law Faculty for helpful comments

and suggestions. An earlier and shorter version of this Article was published as The CoreInstitutions that Support Strong Securities Markets, 55 BUS. LAW. 1565 (2000). The research for thisArticle was substantially completed as of October 2000. The citation style used in this Articledeparts in some cases from the Bluebook citation system.


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2. Specialized Institutions ..........................................................................801D. Which Institutions Are Necessary, Which Are Merely

Nice to Have? ................................................................................................ 803

II. PROTECTING MINORITY INVESTORS AGAINST SELF-DEALING.............................. 804A. Self-Dealing as an Adverse

Selection/Moral Hazard Problem .................................................................. 804B. The Core Institutions that Control Self-Dealing..........................................806C. Additional Useful and Specialized Institutions............................................. 814

III. PIGGYBACKING ON OTHER COUNTRIES INSTITUTIONS........................................ 816A. Estimating the Ease of Piggybacking .............................................................816B. Can Substitute Institutions Facilitate Piggybacking?....................................830

IV. EMPIRICAL EVIDENCE ............................................................................................ 831A. The Qualitative Case for Strong Securities Markets..................................... 832

B. Empirical Evidence: Investor Protection and StrongCapital Markets ............................................................................................. 834C. Empirical Evidence: Investor Protection, Capital Markets,

and Economic Growth .................................................................................. 835V. STRONG AND WEAK SECURITIES MARKETS: A

SEPARATING EQUILIBRIUM?................................................................................... 838

VI. IMPLICATIONS ....................................................................................................... 841A. Different Types of Monitoring: Investor Protection

and Firm Performance ................................................................................... 841B. Competition Between Securities Regulators ................................................. 843C. Convergence in Capital Markets

and Corporate Governance ........................................................................... 845CONCLUSION: WHAT STEPS TO TAKE FIRST ................................................................ 847REFERENCES ..................................................................................................................849

INTRODUCTION

A strong public securities market, especially a public stock market, canfacilitate economic growth. But creating strong public securities markets ishard. That securities markets exist at all is magical, in a way. Investors payenormous amounts of money to strangers for completely intangible rights,whose value depends entirely on the quality of the information that theinvestors receive and on the sellers honesty.

Internationally, this magic is rare. It does not appear in unregulatedmarkets. Aggressive efforts to mass privatize state-owned enterprises and

create stock markets overnight, in formerly centrally planned economieslike Russia and the Czech Republic, have crashed and burned.

1Investor-

1. See Bernard Black, Reinier Kraakman & Anna Tarassova, Russian Privatization and Cor-

porate Governance: What Went Wrong?, 52 STAN. L. REV. 1731 (2000); Edward Glaeser, SimonJohnson & Andrei Shleifer, Coase v. the Coasians, 116 Q.J. ECON. (forthcoming 2001).


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Legal and Institutional Preconditions for Strong Securities Markets 783

protective laws are important, but not nearly enough to sustain strongsecurities markets. Russia, for example, has pretty good laws in theory, butmiserable investor protection in fact. Even among developed countries,only a few have developed strong stock markets that permit growing com-panies to raise equity capital.

This Article explores which laws and related institutions are essentialfor strong securities markets. My goals are threefold: first, to explain thecomplex network of interrelated legal and market institutions that supportsstrong markets in countries, like the United States and the United Kingdom,that have these markets; second, to offer a guide to reforms that canstrengthen securities markets in other countries; and third, to offer somecautionary words about the difficulty of creating this complex network ofinstitutions, and the impossibility of doing so quickly. I also survey theempirical evidence on the correlation between investor protection andsecurities markets, and between securities markets and economic growth.

2

I argue here that there are two essential prerequisites for strong publicsecurities markets. A countrys laws and related institutions must give minor-ity shareholders: (1) good information about the value of a companysbusiness; and (2) confidence that the companys insiders (its managers andcontrolling shareholders) wont cheat investors out of most or all of thevalue of their investment through self-dealing transactions (transactionsbetween a company and its insiders or another firm that the insiderscontrol) or even outright theft. If these two steps can be achieved, a coun-

try has the potential to develop a vibrant securities market that can providecapital to growing firms, though still no certainty of developing such amarket.

3

Individual companies can partially escape weak home-country institu-tions by listing their shares on a stock exchange in a country with strong

2. There is only limited prior work on the prerequisites for strong securities markets. In

addition to the empirical studies discussed in Part IV, infra, see Bernard Black & ReinierKraakman, A Self-Enforcing Model of Corporate Law, 109 HARV. L. REV. 1911 (1996); Bernard S.Black, Information Asymmetry, the Internet, and Securities Offerings, 2 J. SMALL & EMERGING BUS. L. 91(1998); and John C. Coffee, Jr., The Future as History: The Prospects for Global Convergence in CorporateGovernance and Its Implications, 93 NW. U. L. REV. 641 (1999).

3. In Bernard Black, Is Corporate Law Trivial? A Political and Economic Analysis, 84 NW.

U. L. REV. 542 (1990), I argue that American corporate law is mostly trivial, in the sense that itdoesnt significantly constrain the private contractual arrangements that a companys shareholderscan choose for themselves. Some readers of this Article have commented on the tension betweenthe views expressed here and those expressed in my earlier article. A short answer is that I did notclaim then that all of securities law (as opposed to corporate law) was trivial, and I would find lessof securities law trivial today than I might have then. See id. at 565 (questioning the importanceof some securities rules, but recognizing that federal [securities] rules are an important source ofnontrivial corporate law).


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institutions and following that countrys rules. But only partial escape ispossible. A companys reputation is strongly affected by the reputations ofother firms in the same country. And reputation unsupported by localenforcement and other local institutions isnt nearly as valuable as the samereputation buttressed by those institutions.

I dont address here a third aspect of corporate governancehow gooda countrys institutions are at ensuring that managers are competent andseek to maximize profits rather than (say) firm size or their own prestige.Corporate governance debates in the United States and other developedcountries often revolve around this value maximization issue. But formost countries, I believe, value maximization is worth worrying about onlyafter the more basic disclosure and self-dealing issues are addressed. Moreover,I know of no countries that have good financial disclosure and good controlof self-dealing, that dont also (and mostly thereby) have decent manage-ment quality and profit directedness.

4

The interdependence of many of the institutions that control informa-tion asymmetry and self-dealing creates the potential for separating equilibriato exist. In the first lemons equilibrium, most honest companies dontissue shares to the public because weak investor protection prevents themfrom realizing a fair price for their shares. This decreases the average qualityof the shares that are issued, which further depresses prices and discourageshonest issuers from issuing shares. Political demand for stronger investorprotection is muted by the relative scarcity of outside investors. In the sec-

ond strong markets equilibrium, strong investor protection produces highprices, which encourage honest companies to issue shares. This increases theaverage quality of the shares that are issued, which further increases shareprices and encourages more honest issuers to issue shares. Outside investorsthen generate political support for strong investor protection. This Articlecan be seen as an attempt to develop minimum conditions for the strongmarkets equilibrium.

The analysis developed here can inform several current corporate gov-ernance debates. The first debate concerns the merits of bank-centeredversus stock-market-centered capital markets. That debate posits that bank-centered markets offer strong monitoring of management, while stock-

4. Three additional justifications for treating value maximization as a secondary concernare: First, unless managers know (and investors don t) whether the managers are maximizingprofits, good management does not have the adverse selection structure of disclosure, nor thecombined adverse selection/moral hazard structure of self-dealing. It therefore doesnt preventhonest issuers from obtaining a fair price for the shares that they sell. Second, other forces,notably product market competition, are often primary in encouraging good management. Third,controlling information asymmetry and self-dealing will raise share prices, which will increasemanagers private returns from a value maximizing strategy.


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market-centered markets offer liquidity but weaker monitoring. I argue herethat stock-market-centered capital markets provide strong informationdisclosure and control of self-dealingmonitoring dimensions for whichbank-centered capital markets are often weaker.

5Moreover, the standard

debate compares strong bank-centered capital markets to strong stock-market-centered capital markets. It overlooks the many institutions that arecommon to strong capital markets of any sort, as well as the complementari-ties between a strong banking sector and a strong stock market.

My analysis can also inform the debate over the merits of competitionbetween securities regulators. If strong securities markets depend on a com-plex network of market and government institutions, then the debate islargely misplaced. Competition between securities regulators simply cannotexist in anything like the pure form posited by the debaters. Finally, my analy-sis is relevant to the debate over the extent of likely convergence in nationalcorporate governance systems. The institutions that support securitiesmarkets coevolve and reinforce each other. Weakness in one can sometimesbe offset by strength in another. Formal legal rules are only part of a largeweb of market-supporting institutions. This suggests that convergence willsometimes be functional (different countries use different institutions toaccomplish similar tasks) rather than formal (different countries adoptsimilar rules).

I address the prerequisites for a strong securities market in the contextin which they are most acutea public offering of common shares, often by

a company that is selling shares to the public for the first time. Similarthough less acute issues arise when companies issue debt securities.Part I of this Article explains why controlling information asymmetry

is critical for developing strong public stock markets and discusses whichlaws and institutions are most important in doing so. Part II explains whycontrolling self-dealing is also critical and discusses the somewhat differentlaws and institutions that are central for this task. Part III explores theextent to which companies can escape weak domestic laws and institutionsby relying on foreign rules and institutions. Part IV discusses the empiricalevidence of the connection between investor protection and strong securi-ties markets, and between strong securities markets and economic growth.Part V proposes that securities markets may tend toward either a lemons

5. Cf. MARK J. ROE, POLITICAL PRECONDITIONS TO SEPARATING OWNERSHIP FROM

CORPORATE CONTROL: THE I NCOMPATIBILITY OF THE AMERICAN PUBLIC FIRM WITH SOCIALDEMOCRACY (Columbia Law Sch., Ctr. for Law & Econ. Studies, Working Paper No. 155, 1999),available at http://papers.ssm.com/paper.taf/abstract_id=165143 (Social Science Research Net-work) (focusing, unlike this Article, on manager incentives to increase firm value, but also arguingthat the large number of public American firms reflects U.S. success in controlling agency costs).


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or a strong market equilibrium. Part VI develops the implications of myanalysis for the monitoring strengths of stock-market-centered and bank-centered capital markets, competition among securities regulators, and theconvergence of corporate governance systems. I conclude by discussingwhich steps a developing country should take first to strengthen its secu-rities market.

I. INFORMATION ASYMMETRY BARRIERS TO SECURITIES OFFERINGSA. Information Asymmetry and the Role of Reputational Intermediaries

A critical barrier that stands between issuers of common shares andpublic investors is asymmetric information. The value of a companys sharesdepends on the companys future prospects. The companys past perform-ance is an important guide to future prospects. The companys insiders knowabout both past performance and future prospects. They need to deliver thisinformation to investors so that investors can value the companys shares.

Delivering information to investors is easy, but delivering credible infor-mation is hard. Insiders have an incentive to exaggerate the issuersperformance and prospects, and investors cant directly verify the informationthat the issuer provides. This problem is especially serious for small com-panies and companies that are selling shares to the public for the first time.For these companies, investors cant rely on the companys prior reputation

to signal the quality of the information that it provides.In economic jargon, securities markets are a vivid example of a marketfor lemons.

6Indeed, they are a far more vivid example than George Akerlofs

original example of used cars. Used car buyers can observe the car, take atest drive, have a mechanic inspect the car, and ask others about theirexperiences with the same car model or manufacturer. By comparison, acompanys shares, when the company first goes public, are like an unob-servable car, produced by an unknown manufacturer, on which investorscan obtain only dry, written information that they cant directly verify.

Investors dont know which companies are truthful and which aren t, sothey discount the prices they will offer for the shares of all companies. Thesediscounts may ensure that investors receive a fair price, on average. But

consider the plight of an honest companya company whose insiders reporttruthfully to investors and wont divert the companys income stream tothemselves.

6. The obligatory citation here is to George A. Akerlof, The Market for Lemons: Quality

Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488 (1970).


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Discounted share prices mean that an honest issuer can t receive fairvalue for its shares and has an incentive to turn to other forms of financing.But discounted prices wont discourage dishonest issuers. Shares that arentworth the paper theyre printed on are, after all, quite cheap to produce. Thetendency for high-quality issuers to leave the market because they cantobtain a fair price for their shares, while low-quality issuers remain, worsensthe lemons (adverse selection) problem faced by investors. Investors ration-ally react to the lower average quality of issuers by discounting still more theprices they will pay. This drives even more high-quality issuers out of themarket and exacerbates adverse selection.

Some countries, including the United States, have partially solved thisinformation asymmetry problem through a complex set of laws and privateand public institutions that give investors reasonable assurance that theissuer is being (mostly) truthful. Among the most important institutionsare reputational intermediariesaccounting firms, investment bankingfirms, law firms, and stock exchanges. These intermediaries can crediblyvouch for the quality of particular securities because they are repeat playerswho will suffer a reputational loss, if they let a company falsify or undulyexaggerate its prospects, that exceeds their one-time gain from permittingthe exaggeration. The intermediaries backbones are stiffened by liability toinvestors if they endorse faulty disclosure, and by possible government civilor criminal prosecution if they do so intentionally.

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But even in the United States, securities fraudthe effort to sell

shares at an inflated price through false or misleading disclosureis a majorproblem, especially for small issuers. Attempts by skilled con artists to sellfraudulent securities are endemic partly because the United States verysuccess in creating a climate of honest disclosure makes investors (ration-ally) less vigilant in investigating claims by persuasive salesmen about par-ticular companies.

Most American investors still expect financial statements to be audited,shares to be underwritten by an investment banker, and the prospectus tobe prepared by securities counsel. It helps if the issuer is listed on a reputablestock exchange. But investors reliance on reputational intermediariesmerely re-creates the fraud problem one step removed. An environment inwhich most reputational intermediaries guard their reputations creates

an opportunity for new entrants to pretend to be reputational inter-mediaries. Merely calling oneself an investment banker will engender some

7. I use the terms accountants and accounting firms to include the auditing function that

accountants and accounting firms perform. But I refer separately to accounting rules and auditingstandards. On the role of reputational intermediaries in securities markets, see Ronald J. Gilson& Reinier Kraakman, The Mechanisms of Market Efficiency, 70 VA. L. REV. 549, 595607 (1984).


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But SROs need to be policed too, lest they re-create the information asym-metry at yet a third level. Low-quality intermediaries can form a lax SROto vouch for their quality, and investors will then have to figure out whetherthe SRO is itself a bogus intermediary.

9

A third solution combines liability of the intermediaries to investorswith minimum quality standards for intermediaries. Regulators license theintermediaries, fine or revoke the licenses of misbehaving intermediaries,and initiate criminal prosecution if an intermediary misbehaves intention-ally. The greater sanctions available through the legal system, plus theability to collectivize the cost of enforcement (by spreading the cost of pri-vate enforcement through a class action or derivative suit, and the cost ofpublic enforcement through taxes), may explain why liability and licensingstrategies mostly dominate over second-tier reputational intermediaries.

The resulting system, in which multiple reputational intermediariesvouch for different aspects of a companys disclosure, while the government,private plaintiffs, and self-regulatory organizations police the reputationalintermediaries, can work fairly well. But it is scarcely simple. And it mayrequire ongoing government effort to protect reputational intermediariesagainst bogus intermediaries who would otherwise profit from the spilloverof reputation to them.

This complex response to information asymmetry goes a long way towardexplaining why many nations have not solved this problem. Theirsecurities markets have instead fallen into what insurance companies call a

death spiral, in which information asymmetry and adverse selection com-bine to drive almost all honest issuers out of the market and drive shareprices toward zero. In these countries, a few large companies can developreputations sufficient to justify a public offering of shares at a price that,though below fair value, is still attractive compared to other financingoptions. But smaller companies have essentially no direct access to publicinvestors capital.

B. The Core Institutions that Control Information AsymmetryCountries with strong securities markets have developed a number

of institutions to counter information asymmetry. I list below the core

institutions that I consider most important. This list reflects my personaljudgment, based on experience in corporate law and capital markets reform

9. See Glaeser, Johnson & Shleifer (2001), supra note 1 (noting that Czech investment funds

formed self-regulatory organizations, but some of their powerful members were themselvesengaged in tunnelling and opposed strong self-regulation).


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in a variety of countries.10 I present the list in an order that makes logicalsense, not in order of estimated importance. Part III combines this list andthe related list of core institutions that control self-dealing into a singletable.

Effective Regulators, Prosecutors, and Courts

(1) A securities regulator (and, for criminal cases, a prosecutor) that: (a) ishonest; and (b) has the staff, skill, and budget to pursue complex securities disclo-sure cases.

Honest, decently funded regulators and prosecutors are essential. Theytend to be taken for granted in developed countries, but are often partly or

wholly absent in developing countries. Funding is often a hidden problem.The securities regulator may have a minimal budget, or may be hamstrungby salary rules that prevent it from paying salaries sufficient to retain quali-fied people or to keep them honest.

Specialization is needed too. Even in developed countries, few prose-cutors have the skill or interest to bring securities fraud cases. Some securi-ties cases involve outright fraudthe company has reported sales or inventorythat dont exist. An unspecialized prosecutor could potentially bring thesecases, but may prefer to prosecute muggers and murderers instead.Moreover, many securities fraud cases require careful digging through thecompanys records to show how the insiders have twisted the truth, and skillto present the fraud in convincing fashion to a court. And the insiders oftenhave the resources to mount a strong defense.

(2) A judicial system that: (a) is honest; (b) is sophisticated enough to han-dle complex securities cases; (c) can intervene quickly when needed to preventasset stripping; and (d) produces decisions without intolerable delay.

An honest judiciary is a must for investor remedies to be meaningful, butis often partly or wholly absent in developing countries. Decent judicialsalaries are needed if judges are to stay honest. Good training helpsprofessionalism can be a bulwark against corruption. Honest prosecutors

10. My home country is the United States. I have also engaged in significant company and

securities law legal reform work in Armenia, Indonesia, Mongolia, Russia, South Korea, Ukraine,

and Vietnam, and comparative research in Britain and the Czech Republic. See Black, Kraakman& Tarassova (2000), supra note 1; Bernard Black, Barry Metzger, Timothy OBrien & Young MooShin, Corporate Governance in Korea at the Millennium: Enhancing International Competitiveness,(Report to the Korean Ministry of Justice, 2000), 26 J. C ORP. L. (forthcoming 2001), available athttp://papers.ssrn.com/paper.taf?abstract_id=222491 (Social Science Research Network); BernardS. Black & John C. Coffee, Jr., Hail Britannia?: Institutional Investor Behavior Under Limited Regula-tion, 92 MICH. L. REV. 1997 (1994). Below, occasional footnotes use examples from these coun-tries to illustrate points made in the text.


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are an essential support for honest courts, lest a powerful defendant com-bine a bribe if a judge is compliant with a personal threat if she is not.

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The same subtle securities fraud cases that call for specialized prosecutorsrequire sophisticated judges. The ideal would be a specialized court, staffedby judges with prior experience as transactional lawyers. A court in a com-mercial center, which sees a steady diet of business cases, is an acceptablesubstitute.

Speed is important too. When insiders commit fraud, some funds cansometimes be retrieved if the prosecutors can freeze the insiders assetspending the outcome of a case that the prosecutors plan to bring. Other-wise, the money is usually as good as gone. Beyond that, while courtsnowhere move quickly, differences in how fast they move affect the salienceof investor remedies. Moreover, many countries award no or inadequateinterest on judgments, which weakens the official sanctions.

(3) Procedural rules that provide reasonably broad civil discovery and per-mit class actions or another means to combine the small claims of many investors.

Meaningful liability risk for insiders and reputational intermediariesdepends in important part on procedural rules that provide reasonablybroad civil discovery. Proving misdisclosure often requires information thatis buried in the companys records. Also, an individual investor wont oftenincur the expense of a complex lawsuit to recover the investors small pri-vate loss. Its important to have class actions or another way to combinemany individually small claims.

12Contingency fee arrangements are a use-

ful supplement to the class action procedure.

11. A recent Russian example: the 1999 bankruptcy proceedings for Sidanko, a major oil

holding company, and Chernogoneft, a key Sidanko subsidiary. Chernogoneft went bankruptafter selling oil to Sidanko, which failed to pay for the oil and then was looted so badly that itwent bankrupt itself. In the Chernogoneft bankruptcy proceedings, 98 percent of the creditorsvoted for one external manager, but the local judge appointed a different manager with ties to aSidanko competitor, Tyumen Oil, and rejected a Chernogoneft offer to pay all creditors in full.Tyumen bought Chernogoneft for $176 million (a small fraction of actual value), in what Sidankochairman Vladimir Potanin called an atmosphere of unprecedented pressure on the court sys-tem. Indeed, a judge who issued an early ruling against Tyumen was beaten for his troubles. SeeRules of War, ECONOMIST, Dec. 4, 1999, at 65; Jeanne Whalen & Bhushan Bahree, How SiberianOil Field Turned into a Minefield, WALL ST. J., Feb. 9, 2000, at A21, (quoting Potanin); Lee S.

Wolosky, Putins Plutocrat Problem, FOREIGN AFF., Mar.Apr. 2000, at 18, 30. I was an advisor toa minority shareholder in Kondpetroleum (a second Sidanko subsidiary) in litigation against Sidankoand BP Amoco for looting Kondpetroleum.

12. For example, South Korea has respectable rules on information disclosure and self-dealing,and allows contingent fees. But its lack of a class action or similar procedure greatly weakens theincentive for good disclosure. For discussion of Taiwans substitute for a securities class action, seeLawrence S. Liu, Simulating Securities Class Actions: The Case in Taiwan, CORP. GOVERNANCE INTL,Dec. 2000, at 4.


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Stricter rules arent always better. The accounting rules must strike asensible balance among investors desire for information, the cost of providingthe information, and companies concerns about giving detailed infor-mation to competitors. Still, overly flexible rules can reduce comparability,increase opportunities for fraud, and increase information asymmetry betweencompanies and investors.

Auditing standards must be rigorous enough to catch some of the out-right frauds that occur, deter many potential fraud attempts, and discourageat least some attempts at creative accounting.

(6) A rule-writing institution with the competence, independence, andincentives to write good accounting rules and keep the rules up-to-date.

In many countries, the Finance Ministry writes the accounting rules.It often writes rules that provide the information needed to collect taxes,rather than the information needed to attract investment or manage thebusiness. Thus, the rule-writing task is best placed elsewherein a securitiescommission or perhaps, as in the United States and Great Britain, in a quasi-public organization that is loosely supervised by the securities commissionor another regulatory agency.16

Writing good accounting rules requires close knowledge of how com-panies operate, understanding of the loopholes in the existing rules, appre-ciation for changes in corporate practices, and the ability and incentiveto write new rules and interpret old ones with reasonable dispatch.17 Thisoffers some reason to vest rule writing in a quasi-public organization, rather

than a government agency. If the rule-writing body is private, its funding andthe manner of choosing its members must ensure that the agency isnt overlydependent on issuers, whose managers often prefer opaque disclosure,especially about their own compensation.

Reputational Intermediaries

(7) A sophisticated accounting profession with the skill and experience tocatch at least some instances of false or misleading disclosure.

Audit requirements and accounting rules are no better than the account-ants who conduct the audits and interpret the rules. Auditing and account-ing are part science (following established rules), but in part remain a skilled

16. For an overview of U.S. and British practice in setting accounting rules and the advan-

tages and disadvantages of self-regulation, see BRIAN R. CHEFFINS, COMPANY LAW: THEORY,STRUCTURE, AND OPERATION 372420 (1997).

17. For some good examples of how accounting rules need to respond to changing businesspractices, see Louis Lowenstein, Financial Transparency and Corporate Governance: You ManageWhat You Measure, 96 COLUM. L. REV. 1335 (1996).


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(9) A sophisticated investment banking profession that investigates securitiesissuers because the investment bankers reputation depends on not selling overpricedsecurities to investors.

Investment bankers are a second key reputational intermediary. Theywalk a fine line between selling an offering and overselling it. Their roleincludes conducting a due diligence investigation of the issuer and satis-fying themselves that the offering documents and road show presentationsreasonably portray the issuers prospects, the major risks of the investmentare disclosed, and the issuers managers are honest. For example, investmentbanks routinely conduct background checks on company insiders and walkaway if the insiders have an unsavory past or dubious friends.

Investment bankers reputations are policed in a number of ways. Secu-rities purchasers will remember if an investment bank sells them several badinvestments and avoid its future offerings. Investment banks track the after-market performance of their own and their competitors offerings and happilydisclose competitors weak performance to potential clients. And when anunderwriter sells shares for a fraudulent company, which later collapsein price when the fraud is discovered, this is a major embarrassment, notsoon forgotten by investors or the banks competitors. So too for a debtoffering that quickly goes into default.

(10) Securities or other laws that impose on investment bankers enough riskof liability to investors if the investment bankers underwrite securities that are soldwith false or misleading disclosure, so that the bankers will resist their clients

entreaties for more favorable disclosure.Liability to investors can reinforce investment bankers concern forreputation. Liability can persuade an investment bank to turn away mar-ginal issuers. It can persuade the firm to establish internal review proce-dures to ensure that its offerings meet minimum quality standards. Andliability risk provides a compelling argument that the investment bank canoffer to a client that wants more favorable disclosure than the bank proposes.

As for accountants, I make no claim that frequent litigation againstinvestment bankers is important. A few lawsuits per decade, a couple ofwhich result in a significant payout, could be enough. But if there is no liabil-ity risk, individuals within a firm will sometime accept the ever-presenttemptation to squander the firms reputation to gain a client and a fee.

(11) Sophisticated securities lawyers who can ensure that a companysoffering documents comply with the disclosure requirements.

Securities lawyers are a third major reputational intermediaryalbeitless visible to investors than accountants or investment bankers. They walka fine line between accepting the positive-sounding statements that theissuer wants to make and insisting on the need to disclose risks and problems.


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The lawyers role in disclosure is likely to depend on whether compa-nies, insiders, and investment bankers face meaningful liability risk. If so,then companies and investment bankers will protect themselves by hiringlawyers to write and review the key disclosure documents. The lawyerscaution (deriving from the need to protect ones client against liability) willhelp to ensure good disclosure, even if lawyers face little liability risk them-selves. Conversely, if companies and investment bankers face little risk,they may forego hiring expensive securities lawyers to write disclosuredocuments, or reject the lawyers cautionary advice, and disclosure qualitywill suffer.

(12) A stock exchange with meaningful listing standards and the willingnessto enforce them by fining or delisting companies that violate disclosure rules.

Stock exchanges are a fourth important reputational intermediary.They establish and enforce listing standards, including disclosure require-ments. Investors use the listing as a proxy for company quality. Bothinvestors and exchanges understand that false disclosure by a few companieswill taint all listed companies. Historically, stock exchange listing ruleswere an important factor in the rise of dispersed ownership in the UnitedStates and the United Kingdom.

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Company and Insider Liability

(13) Securities or other laws that impose liability and other civil sanctionson companies and insiders for false or misleading disclosure.

Reputational intermediaries are a second line of defense against securi-ties fraud. The primary defense is direct sanctions against companies andinsiders who attempt fraud.

Companies often want to be able to issue shares in the future; insiderswant to be able to sell their shares at an attractive price in the future. Thatgives insiders an incentive to develop the companys reputation for honestdisclosure. But some of the time, the company needs funds now, or therewont be a next time. In game theory terms, the insiders are in the finalperiod of a repeated game. They have an incentive to cheat because therewont be a next round in which the cheating can be punished.

20At other

times, the insiders face a final period because their tenure in the company is

19. See Cheffins (2001), supra note 13; JOHN C. COFFEE, JR., THE RISE OF DISPERSED

OWNERSHIP: THE ROLE OF LAW IN THE SEPARATION OF OWNERSHIP AND CONTROL (ColumbiaLaw Sch., Ctr. for Law & Econ. Studies, Working Paper No. 182, 2001), available at http://papers.ssrn.com/paper.taf?abstract_id=254097 (Social Science Research Network); Mahoney (1997),supra note 13.

20. See generally ROBERT AXELROD, THE EVOLUTION OF COOPERATION (1984).


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(16) Rules banning manipulation of trading prices (and enforcement of thoserules).

Transparent market prices raise their own dangers. Especially in thinmarkets, insiders can manipulate trading prices to create the appearancethat a companys shares are highly valued, while dumping their own shareson the market. Rules against manipulating trading prices are the principalresponse to this risk. These rules need to be enforced by a specialized regu-lator, because manipulation is notoriously hard to prove.

22

Culture and Other Informal Institutions

(17) An active financial press and securities analysis profession that can

uncover and publicize misleading disclosure and criticize company insiders and(when appropriate) investment bankers, accountants, and lawyers.

Reputation markets require a mechanism for distributing informationabout the performance of companies, insiders, and reputational intermedi-aries. Disclosure rules help, as do reputational intermediaries incentivesto advertise their successes. But intermediaries wont publicize their ownfailures, and investors will discount competitors complaints because theycome from a biased source. An active financial press is an important sourceof reporting of disclosure failures. But libel laws that make it easy forinsiders to sue their critics (using company funds) can chill reporting. In acountry without honest courts and prosecutors, journalists are vulnerable tocruder threats as well.23

Security analysts are another important source of coverage. They mustbalance the need to maintain a reputation for objectivity against pressurefor positive coverage from companies (who can retaliate for negative cover-age by cutting off the analysts access to soft information), and (for analystswho are employed by investment banks) from their own employer not to

22. Daniel Fischel and David Ross argue that all, and Omri Yadlin argues that some,manipulation should be legal. See Daniel R. Fischel & David J. Ross, Should the Law ProhibitManipulation in Financial Markets?, 105 HARV. L. REV. 503 (1991); Steve Thel, $850,000 in SixMinutesthe Mechanics of Securities Manipulation, 79 CORNELL L. REV. 219 (1994) (criticizingFischel and Ross); Omri Yadlin, Is Stock Manipulation Bad?: Questioning the Conventional Wisdomwith Evidence from the Israeli Experience, 3 THEORETICAL INQUIRIES L. (forthcoming 2001). ForYadlin, it is fine for General Motors to sell shares of Fisher Body in the market, for the purpose of

depressing the trading price so that General Motors can acquire all of Fisher Body at a lower price,as long as the managers of General Motors believe that Fisher Bodys standalone value is lowerthan its market price. The problem is that in any successful manipulation, including those thatYadlin likes, informed investors profit and uninformed investors lose. Uninformed investingbecomes less profitable, which increases the information asymmetry discount that investors applyto all shares.

23. For examples of physical retaliation by Russian businessmen against reporters and othercritics, ranging from beatings to murder, see Black, Kraakman & Tarassova (2000), supra note 1.


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say nasty things about a client or potential clientin other words, aboutany company at all! Nonetheless, analysts often uncover aggressive finan-cial reporting by particular companies. The financial press can help ana-lysts maintain a tolerable balance between disclosing bad news and pleasingcompanies and their own employers, by rating analysts reputations amonginvestors.

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(18) A culture of disclosure among accountants, investment bankers, law-yers, and company managers, who learn that concealing bad news is a recipe fortrouble.

In countries with strong securities markets, the sanctions againstmisdisclosure reinforce a culture of compliance, in which a bit of puffingis acceptable, but outright lying is not. Accountants, investment bankers,and lawyers see themselves as professionals, and (mostly) behave accord-ingly. Moreover, few managers will attempt clearly illegal actions, becausedisclosure is the norm and others are occasionally disgraced or sent to jailfor falsifying financial statements.

This long list of institutions underscores the difficult task facing acountry that wants to develop a strong securities market. Formal disclosurerules are important, but are not enough. The harder task is enforcing therulesboth direct public enforcement and indirect enforcement throughprivate institutions, especially reputational intermediaries.

C. Additional Useful and Specialized InstitutionsThe list of core institutions in Part B reflects my personal judgment

about which rules and institutions are most important for ensuring gooddisclosure. This part lists some additional institutions that I consider usefulbut not core.

1. Useful Institutionsa. Licensing of reputational intermediaries. Its useful for accountants

and investment bankers to be subject to a regulatory licensing scheme. Idont list regulatory licensing as a core institution because I believe thatfor reputational intermediaries, private enforcement (through liability to

24. An American example is the analyst rankings published annually by Institutional Inves-tor magazine. SeeThe 1999 All-America Research Team, INSTITUTIONAL INVESTOR, Oct. 1999, at109 (rankings available at http://www.iimagazine.com/research/99/aart/best.html). Analysts valuehigh rankings, which significantly increase their expected income and job mobility. On the roleplayed by analysts in reducing information asymmetry, see ZOHAR GOSHEN, ON INSIDERTRADING, MARKETS, AND NEGATIVE PROPERTY RIGHTS IN INFORMATION (working paper,2000).


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investors) is likely to be more effective than public enforcement (throughregulatory sanctions). Even in countries with strong regulators, regulatorysanctions are usually imposed only in egregious cases. Emerging economieshave fewer regulatory resources and better uses for those resources. Prose-cuting insiders who commit fraud is often a higher priority for regulatorsthan sanctioning the intermediaries who merely failed to catch the fraud.

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b. Self-regulatory organizations. Self-regulation, through a voluntary ormandatory self-regulatory organization that is itself subject to regulatoryoversight, is a useful supplement to government regulation of reputationalintermediaries. Just as liability to investors makes reputational intermedi-aries more willing to insist on good disclosure, it makes the intermediariesmore willing to create a strong SRO and support the SROs efforts to disci-pline errant members.

c. Lawyer liability. For securities lawyers, liability to investors is lessimportant than for accountants and investment bankers, and hence notlisted above as a core institution. Lawyers are already concerned aboutliability because of their training and have an incentive to protect theirclients against liability. Lawyers have reputations to preserve too, and havingclients lose disclosure lawsuits isnt good for business. But some risk ofliability to investors is a useful supplement to lawyers professional caution.

d. Independent directors. Investment bankers, accountants, and secu-rities lawyers are the principal outside reviewers and writers of disclosuredocuments. But independent directors can sometimes catch disclosure

problems that the intermediaries miss. The independent directors can be seenas second-tier reputational intermediaries. Their incentive to review thedisclosure with a skeptical eye can usefully be reinforced by a touch of legalliability to investors. But the independent directors shouldnt face too muchliability risk, lest skilled directors refuse to serve. In countries where mostcompanies have a controlling shareholder, mandatory cumulative votingcan be useful because it allows minority shareholders to elect one or twotruly independent directors, and can strengthen a culture of directorindependence.

e. Investment funds and related institutions. Investment funds (Ameri-cans call them mutual funds, for some odd reason) are another usefulinstitution. They provide individual investors with diversification and some

protection against claims by con artists (who will have a harder time foolingexperts than novices). An investment fund industry can strengthen the secu-

25. For more general discussion of the reasons to believe that rules that can be privately

enforced are likely to be more effective in emerging countries than rules that require publicenforcement, see Black & Kraakman (1996), supra note 2, at 192943.


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rities market by providing a source of investable funds, as well as market andpolitical demand for strong disclosure. I dont list investment funds as acore institution because, in my judgment, a healthy investment fund indus-try is more a result than a cause of a strong securities market.

The investment fund industry relies on still other related institutions.These include an investment fund law that protects the funds assets againstself-dealing by the fund managers, a regulator that polices the industry andlimits fund managers ability to make inflated claims of past or expectedfuture performance, and a financial press that rates fund performance.

f. Pension plans. Funded employee pension plans are a further usefulinstitution. Like investment funds, they are a source of investable fundsand market and political demand for good disclosure.

g. A sensible tax system. A confiscatory tax system (Russias, say) pre-cludes honest reporting of profits, and thus precludes good disclosure. Moregenerally, private firms can be more aggressive than public firms in taxplanning and outright tax evasion. Thus, high tax rates weaken securitiesmarkets by inducing more firms to stay private. And a high stamp tax onsecurities transactions can shrink, perhaps dramatically, the size of the secu-rities market.

26

h. Other useful institutions. Even this further list of useful institutionsomits a number of institutions that support an advanced securities market.Additional institutions include: compliance officers within investmentbanks, who help to ensure that investment bankers desire for fees wont

override concern for legal niceties or long-term reputation; an audit com-mittee of the board of directors, which can give a company s auditors someprotection against management pressure for lenient treatment; insideaccountants and lawyers, who are acculturated to honest disclosure andhelp to make fraud harder to undertake; and so on.

2. Specialized InstitutionsFor particular types of companies or preferred stock and debt, addi-

tional institutions can be important, even crucial.a. Venture capital. Investors in high-technology companies face severe

information asymmetry problems, because these companies often have

short histories, make highly specialized products, participate in fast-moving

26. See COFFEE (2001), supra note 19 (discussing Germanys 1896 stamp tax); cf. ChristopherJ. Green, Paolo Maggioni & Victor Murinde, Regulatory Lessons for Emerging Stock Markets from aCentury of Evidence on Transactions Costs and Share Price Volatility in the London Stock Exchange, 24

J. BANKING & FIN. 577 (2000) (reporting evidence that stamp taxes depress trading volume andincrease volatility).


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industries, and have growth prospects (and thus value) that can t be easilyextrapolated from past financial results. As a result, countries with strongstock markets, such as the United States, have developed a specializedinstitutionthe venture capital fundthat funds high-technology com-panies early in their life and functions in significant part as a specializedreputational intermediary. Venture capital funds closely investigate com-panies that seek funding, and then implicitly vouch for these companieswhen they later raise capital in the securities markets.

Venture capital financing involves synergy between the venture capi-talists visible role in providing financial capital and their equally importantrole in providing reputational capital and monitoring. For early stage, high-technology companies, combining these three services dominates over thealternative, offered by public securities markets, of providing financial capi-tal without close monitoring, or the alternative of providing monitoring andreputational capital without investing, which is a plausible institutionalarrangement that we dont see.

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If developing a strong public stock market is hard, developing a strongventure capital industry is harder still. Venture capital funds face a classicchicken and egg problem in getting starteda venture capitalist cant getfunding until he develops a reputation for making good investments, butcant develop a reputation without making investments. Thus, the initialstages of industry development are likely to be slow.

b. Bond rating agencies. For bonds and other fixed-income invest-

ments, bond rating agencies such as Moodys and Standard & Poors offerquality ratings for different issuers. In the United States, rating agenciesmore often follow the bond market than lead it. But the rating agencies area significant reputational intermediary in less-developed markets, wherethey provide both company ratings and country-risk ratings that are noteasily or credibly obtained in another way.

28

27. See Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital

Markets: Banks Versus Stock Markets, 47 J. FIN. ECON. 243 (1998); see also Thomas Hellmann &Manju Puri, The Interaction Between Product Market and Financing Strategy: The Role of Venture

Capital, 13 REV. FIN. STUD. 959 (2000). For evidence on the role of venture capital funds asreputational intermediaries, see Alon Brav & Paul A. Gompers, Myth or Reality? The Long-RunUnderperformance of Initial Public Offerings: Evidence from Venture and Nonventure Capital-BackedCompanies, 52 J. FIN. 1791 (1997), and Paul Gompers & Josh Lerner, Conflict of Interest in the Issu-ance of Public Securities: Evidence from Venture Capital, 42 J.L. & ECON. 1 (1999).

28. For a recent negative review of the role played by rating agencies in American capitalmarkets, see Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for theCredit Rating Agencies, 77 WASH. U. L.Q. 619 (1999).


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c. Money manager rating services. For money managers who managepension funds and other institutional assets, a cottage industry has arisen ofconsulting firms who verify the money managers performance claims, anda related industry that develops performance indexes against which the per-formance of a money manager with a particular style or investment focuscan be measured.

D. Which Institutions Are Necessary, Which Are Merely Nice to Have?My long list of core institutions for ensuring good disclosure, and the

additional core institutions for controlling self-dealing discussed in Part II,raise an obvious question: Which institutions are really necessary, and

which are just extra frosting on an already tasty cake? Underlying thatquestion is American and British experience, in which strong securitiesmarkets developed together with some of these institutions but predatedothers. For example, the United States had active securities markets longbefore it had a strong central securities regulator (though the states earlyregulated securities offerings). The United States didnt enforce insidertrading rules (an institution that I consider important for controlling self-dealing) until the 1960s. In Britain, many stock promoters invested little inreputation until perhaps the middle of the twentieth century, arguably afterBritain had already developed a strong stock market.

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The interrelationships among institutionscomplements in some

respects, substitutes in othersmean that there is no simple answer to thisquestion. One must evaluate how important each institution is, both byitself (to the extent feasible) and as part of an overall system. Considerinsider trading. Utpal Bhattacharya and Hazem Daouk report that anenforced ban on insider trading raises share prices by about 5 percent, otherthings equal.

30That suggests that such a ban is important enough to be

considered a core institution, but not absolutely critical. A stock marketcan be strong without controls on insider trading; it will be stronger withthese controls.

On the other hand, local enforcement is critical, and therefore honestcourts and regulators are critical. A strong stock market cannot exist if

29. See Cheffins (2001), supra note 13.30. See UTPAL BHATTACHARYA & HAZEM DAOUK, THE WORLD PRICE OF INSIDER

TRADING (working paper, 1999), available at http://papers.ssrn.com/paper.taf?abstract_id=200914(Social Science Research Network).


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major players can escape liability by bribing a judge to forgive their tres-passes, bribing a prosecutor or a regulator to ignore them, or bribing politiciansto call off the prosecutors or regulators. I cant prove this, but neither can Ithink of any counterexamples.

II. PROTECTING MINORITY INVESTORS AGAINST SELF-DEALINGA. Self-Dealing as an Adverse Selection/Moral Hazard Problem

The second major obstacle to a strong public stock market is thepotential for insiders to appropriate most of the value of the company forthemselvesfor 50 percent of the voting shares (less if the remainder arediffusely held) to convey most or all of the companys value.

Self-dealing can occur in many variants. But a useful division isbetween:

(1) direct self-dealing, in which a company engages in transactions,not on arms-length terms, that enrich the companys insiders, theirrelatives, or friends, or a second company that the insiders control;and

(2) indirect self-dealing (often called insider trading), in whichinsiders use information about the company to trade with less-informed investors.

Direct self-dealing is a much more important problem than insider

trading. First, its far more profitable. Direct self-dealing lets insiders turn(say) 40 percent ownership of shares into up to 100 percent ownership offirm value, with little additional investment. Insider trading cant producesimilar gains. For one thing, insider trading in significant volume requires aliquid stock market, which countries that dont control direct self-dealingwont have. For another, long-term buy-and-hold investors arent directlyharmed by insider trading. You can only be on the losing side of a tradewith an insider if youre trading.

More critically, if direct self-dealing is hard to control, insider tradingin anonymous securities markets is even harder to control. Without theinstitutions that control direct self-dealing, there is little hope of control-ling insider trading. But the converse isnt true. A country can control

direct self-dealing fairly well without making the additional investmentneeded to address insider trading.

The potential for self-dealing creates a lemons (or adverse selection)problem, which has the same structure as the adverse selection problemcreated by asymmetric information. Investors dont know which insidersare honest and which will appropriate most of the companys value, so they


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discount all companies share prices. This creates a dilemma for honestinsiders who wont divert the companys income stream to themselves.Discounted share prices mean that a company with honest insiders cantreceive fair value for its shares. This gives the company an incentive to useother forms of financing. But discounted prices wont discourage dishonestinsiders. The prospect of receiving even a discounted price for worthlesspaper will be attractive to some insiders.

This adverse selection by issuers, in which high-quality companiesleave the market because they cant obtain a fair price for their shares whilelow-quality companies remain, lowers the average quality of issuers. Inves-tors rationally react by further discounting share prices. This drives evenmore high-quality issuers away from the market and exacerbates adverseselection. As with asymmetric information, failure to control self-dealingcan result in a death spiral, in which self-dealing and adverse selectioncombine to drive almost all honest issuers out of the market and drive shareprices toward zero, save for a few large companies that can develop theirown reputations.

Self-dealing is a harder problem to solve than information asymmetry.First, honest disclosure of information during a public offering of sharescant later be undone. In contrast, after a company sells shares, its insidershave an incentive to renege on a promise not to self-deal and capture moreof the companys value than investors expected when they bought theshares. Again, insurance terminology is helpfulthe incentive to renege is

known as moral hazard. This incentive is only imperfectly policed by theinsiders concern for reputation to permit future offerings by the company orfuture sales by insiders of their own shares.

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Second, false or misleading disclosure in a public offering often occursin a formal disclosure document and thus leaves a paper trail. If subsequentevents reveal business problems that the company concealed, the disclosuredeficiencies will often be obvious enough to let investors and regulatorsseek damages or other sanctions against the insiders and, if appropriate, thereputational intermediaries. In contrast, self-dealing is often hidden. Itmust be uncovered before it can be policed.

Third, a securities offering is a discrete event that lets investors insiston participation by reputational intermediaries. Self-dealing lacks a similar

triggering event. The accountants annual audit is an important check on

31. For discussion of moral hazard in organizations, see PAUL MILGROM & JOHN ROBERTS,

ECONOMICS, ORGANIZATION AND MANAGEMENT 166204 (1992).


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self-dealing, and securities lawyers can play a role if they prepare the com-panys public disclosure filings, but investment bankers recede into thebackground.

Fourth, once a company issues shares at a discount, the insiders mayfeel entitled to appropriate most of the companys value for themselves.They will resist any change in legal rules that limits this opportunity. Anexample can illustrate why insiders can feel this way. Assume thatCompany A has fifty outstanding shares worth $2 each (for a total value of$100), all held by insiders. Outside investors may be willing to pay only50 per share for additional shares, both because the investors dont knowthe companys true value and because they expect insiders to appropriatemost of whatever value exists. Suppose that Company A issues fifty addi-tional shares at this price. Company A now has one hundred shares out-standing, fifty shares held by insiders and fifty held by outside investors, anda total value of $125.

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If the insiders keep only 50 percent of the companys value, they havecheated themselves. Their shares will be worth only $62.50, while the out-side investors shares will be worth $62.50far more than the outsideinvestors paid. The insiders rational response is to self-deal enough tocapture at least 80 percent of the firm s value$100 out of the total valueof $125. They will not feel that they have cheated anyone by doing so, andwill fight legal and institutional reforms that might prevent them fromtaking what they see as their fair share of their companys value.

But in opposing reforms, insiders of already public companies reinforcea system that wont prevent them from taking more than 80 percent of thecompanys value if they chooseand some insiders will so choose. If anational system permits substantial self-dealing, often in hidden forms,there is no obvious way to ensure that investors get the fraction of anyparticular companys value that they paid for, or even to know what thatfraction is.

B. The Core Institutions that Control Self-Dealing Just as successful securities markets have developed institutions to

counter information asymmetry, they have developed institutions to

counter self-dealing. My judgmental list of core institutions is presentedbelow, in an order that makes logical sense, not in order of estimatedimportance. Some of these are the same institutions that control informa-tion asymmetry; some are different. Part III combines this list and the list

32. This example is adapted from Coffee (1999), supra note 2, at 65759.


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of core institutions for controlling information asymmetry into a singletable.

Effective Regulators, Prosecutors, and Courts

Honest, decently funded judges, regulators, and prosecutors are, if any-thing, even more critical for controlling self-dealing than for controllinginformation asymmetry, because reputational intermediaries play a smallerrole for self-dealing transactions.

(1) A securities regulator (and, for criminal cases, a prosecutor) that: (a) ishonest; and (b) has the staff, skill, and budget to untangle complex self-dealingtransactions.

Insiders often use transactional complexity and multiple intermediariesto hide their interest in a transaction, and anonymous offshore accounts tohide insider trading. Proving a self-dealing case often requires developinga chain of circumstantial evidence that will befuddle ordinary prosecutors,or at least lead them to seek out easier cases. And insiders often have thewealth to mount a vigorous defense.

(2) A judicial system that: (a) is honest; (b) is sophisticated enough to under-stand complex self-dealing transactions; (c) can intervene quickly when needed toprevent asset stripping; and (d) produces decisions without intolerable delay.

As for information asymmetry, honest, sophisticated, and decently paidjudges are basic and often absent, as is the courts ability to reach decisionswith reasonable dispatch and to freeze assets before they are moved offshore.

(3) Procedural rules that provide reasonably broad civil discovery, permitclass actions or another means to combine the small claims of many investors, andaccept proof of self-dealing through circumstantial evidence.

As for information asymmetry, meaningful liability risk requires notjust formal liability rules, but also procedural rules that provide reasonablybroad civil discovery. Class actions or another means to aggregate indi-vidually small claims are also important.

The need for broad discovery is even more crucial for self-dealing thanfor information asymmetry. For misdisclosure in a public offering, thereis usually a written disclosure document that will sometimes be false on itsface. In contrast, for self-dealing, insiders are dealing with themselves, or

(for insider trading) with an anonymous market. They can often avoida telltale paper trail. The judicial system must therefore permit wrongdoingto be inferred from circumstantial evidence.

33Rules that shift the burden to

33. In Russia, for example, even if judges were honest, self-dealing could rarely be proven

because courts insist on documentary proof of almost all factual assertions.


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insiders to disprove self-dealing (once suspicious circumstances are established),or require the insiders to prove fairness (once self-dealing is established),can be highly valuable.

Disclosure Requirements and Procedural Protections

(4) Securities or other laws that require extensive disclosure of self-dealingtransactions.

Insiders wont voluntarily announce to the world that they are engagedin self-dealing. Strong auditing standards and disclosure rules are needed,because if self-dealing transactions can be hidden, none of the other protec-tions will be very effective.

(5) Company or securities law that establishes procedural protections for self-dealing transactions, such as approval after full disclosure by independent direc-tors, noninterested shareholders, or both.

Disclosure alone will deter some self-dealing. But much self-dealingwill still take place if the underlying transactions are lawful. Thus, signifi-cant self-dealing transactions should be subject to review by independentdirectors, noninterested shareholders, or both.

In the United States, with a culture of independence for outside direc-tors and skilled courts that can ferret out self-dealing when a shareholdersues ex post, it may be sufficient to vest approval power solely in the inde-pendent directors. But often, nominally independent directors wont be veryindependent in fact, especially when a company has a controlling share-holder, at whose pleasure the directors serve. Thus, it can be valuable to giveapproval power for larger transactions to noninterested shareholders.

34

(6) Ownership disclosure rules, so that outside investors know who the insid-ers are and interested shareholders cant vote to approve a self-dealing transactionthat requires approval by noninterested shareholders.

Insiders have an incentive to disguise their ownership, both in a com-pany and other entities that the company transacts with, to conceal a transac-tions self-dealing nature. If noninterested shareholders have veto power overself-dealing transactions, insiders have a further incentive to hide their shareownership so they can pretend to be noninterested. Disclosure rules, plusrules that treat affiliates of insiders as interested shareholders, can prevent

this practice.More generally, if self-dealing is a significant risk, outside investorsneed to know who the insiders are. This will help the outside investors deter-

34. For discussion of the choice between ex ante and ex post controls on self-dealing in a

transition economy, see Black & Kraakman (1996), supra note 2, at 193234, 195860.


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transaction. Professionalism is one bulwark against this temptation, but liabil-ity to investors is an important bulwark for professionalism.

(11) Sophisticated securities lawyers who can ensure that companies satisfythe disclosure requirements governing self-dealing transactions.

A disclosure document for a self-dealing transaction, developed to obtainshareholder approval for the transaction, or annual disclosure that lists self-dealing transactions during the past year, will commonly be prepared bysecurities counsel. An important safeguard of accuracy is counsels willingnessto insist on full disclosure, conduct enough due diligence to satisfy themselvesthat the disclosure is accurate, and warn insiders about the risks of partialdisclosure.

(12) Law or custom that: (a) requires public companies to have a minimumnumber of independent directors; (b) ensures that they approve self-dealing trans-actions; and (c) imposes on companies and independent directors enough risk ofliability if they approve self-dealing transactions that are grossly unfair to thecompany so that the directors will resist the insiders pressure to approve thesetransactions.

Approval by independent directors is an insufficient safeguard againstself-dealing transactions in countries where the directors independence isin doubt, but this approval is still an important safeguard. The directorspersonal liability if they dont behave independently is a central support forthis constraint. Company liability can help to persuade the independentdirectors to reject transactions that arent on arms-length terms. Liability

also offers a powerful argument that the independent directors can use wheninsiders propose a dubious transaction.Independent directors must be given the benefit of the doubt when

they approve a transaction, lest the best directors decline to serve for fear offinancial liability. But if self-dealing is egregious enough, the need for liabil-ity, to strengthen the directors backbones, outweighs the chill on theirwillingness to serve. After all, the independent directors can always reject atransaction, ask an outside expert to approve the terms as fair, or insist onapproval by noninterested shareholders.

Insider Liability

(13) Civil liability for insiders who violate the self-dealing rules.Oversight by reputational intermediaries, and requirements that self-dealing transactions must be approved by independent decision makers, areimportant devices to enhance detection of attempted theft (for that is whatself-dealing must be understood as). But they are no substitute for direct rulesagainst theft and meaningful liability for thieves who are caught. The prin-


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(17) Rules ensuring transparent trading prices.Insider trading flourishes in the dark. The better the trading price is as

a guide to actual value, the harder it is for insiders to profit from tradingwith outsiders. This requires not only general financial disclosure, but alsorules ensuring transparent trading prices.

(18) Rules banning manipulation of trading prices (and enforcement of thoserules).

Public reporting of trades lets insiders manipulate trading prices. Pumpand dump schemes, in which insiders of small companies use prearrangedtransactions at rising prices to create the appearance of a hot stock, and thensell their own shares at inflated prices, are an endemic problem even in devel-oped markets. Enforcement of antimanipulation rules by specialized regula-tors is the only remedy.

Culture and Other Informal Institutions

(19) An active financial press and securities analysis profession that canuncover and publicize instances of self-dealing.

Insiders will self-deal less often, and accountants, securities lawyers,and independent directors will be more vigorous in policing self-dealing, if acountry has a strong financial press that can publicize misdeeds. As forinformation asymmetry, overly strong libel laws can chill press reporting.

Reports that uncover self-dealing will often come from securitiesanalysts rather than the financial press. The more prevalent self-dealing isin a particular country, the greater the need for analysts to understand howself-dealing varies from company to company, both to value companies andto advise clients on which securities to buy.

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(20) A culture of compliance among accountants, lawyers, independentdirectors, and company managers that concealing self-dealing transactions, approv-

37. Two Russian examples: First, the Troika Dialog investment bank publishes a weekly

news bulletin, On Corporate Governance Actions, that advises its clients in surprisingly blunt terms

about corporate governance shenanigans by Russian companies. See also JAMES FENKNER & ELENAKRASNITSKAYA, CORPORATE GOVERNANCE IN RUSSIA: CLEANING UP THE MESS (Troika Dialog,1999). Second, the Brunswick Warburg investment bank published a numerical ranking of thecorporate governance risk posed by Russian firms, with risk ratings ranging from 7 for Vimpelcom(which publishes financial statements that meet U.S. accounting standards and has shares listedon the New York Stock Exchange) to 51 for the subsidiaries of Yukos. See BRUNSWICK WARBURG,MEASURING CORPORATE GOVERNANCE RISK IN RUSSIA (1999). Yukos misdeeds are recountedin Black, Kraakman & Tarassova (2000), supra note 1.


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Incremental steps can help. For example, Italy and Germany havetaken important steps in the last several years toward improving disclosure.These countries have also experienced a significant increase in initial pub-lic offerings and in the ratio of market capitalization to Gross DomesticProduct (GDP). I doubt that this is a coincidence. Italy and Germany couldfurther strengthen their stock markets if they also enhanced their proceduralprotections against self-dealing transactions. But these changes dont comeeasily. The German and Italian disclosure rules were controversial, partlybecause they transfer wealth in already public companies from insiders tooutside shareholders.

C. Additional Useful and Specialized InstitutionsThe list of core institutions in Part B reflects my personal judgment

about which rules and institutions are the most important for controlling self-dealing. It is not a complete list of the useful rules and institutions. This partdiscusses some additional institutions that I consider useful, but not core.

a. One share, one vote. A one-share, one-vote rule that limits thedisparity between voting control and economic rights will reduce insiders incentives to self-deal. So will rules that restrict pyramid ownershipstructures.

41

b. A takeout bid requirement. A mandatory takeout bid rule requires anew controlling shareholder to offer to buy out all other shareholders at a

per share price comparable to the price that the controlling shareholderpaid to acquire control, unless the minority shareholders waive this right fora particular transaction. These rights give comfort to outside investors that,while they must trust the companys current controlling shareholders, theyhave an assured exit, at a reasonable price, if control changes hands.

42

in prospect, Goldman Sachs didnt want to know otherwise. See Joseph Kahn & TimothyOBrien, For Russia and Its U.S. Bankers, Match Wasnt Made in Heaven, N.Y. TIMES, Oct. 18,1998, at 1. (I advised Dart Management, a major shareholder in the Yukos subsidiaries, in theireffort to persuade Goldman Sachs that the transaction was illegal.)

41. For evidence on the value of a one share, one vote rule, see STIJN CLAESSENS, SIMEOND. DJANKOV, JOSEPH P.H. FAN & LARRY H.P. LANG, ON EXPROPRIATION OF MINORITYSHAREHOLDERS: EVIDENCE FROM EAST ASIA (World Bank, Working Paper No. 2088, 1999),available at http://papers.ssrn.com/paper.taf?abstract_id=202390 (Social Science Research Net-

work). On the theoretical effects of pyramid structures, see Lucian Bebchuk, Reinier Kraakman& George Triantis, Stock Pyramids, Cross-Ownership, and Dual Class Equity: The Creation and

Agency Costs of Separating Control from Cash Flow Rights, in CONCENTRATED OWNERSHIP 295(Randall K. Morck ed., 2000). On their prevalence, see Stijn Claessens, Simeon D. Djankov &Larry H.P. Lang, The Separation of Ownership and Control in East Asian Corporations, 58 J. FIN.ECON. 81 (2000).

42. See COFFEE (2001), supra note 19 (abstract) (stressing the need, as a precursor to dis-persed shareholding, to protect the public shareholder from stealth acquisitions of control).


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c. Preemptive rights and redemption rights. Especially in a country withweak overall constraints on self-dealing, company law rules giving minorityshareholders redemption rights (Americans call them appraisal rights) formergers and other major transactions, and preemptive rights during publicofferings of shares and convertible securities, can provide useful protectionagainst some common forms of self-dealing.

d. Public reporting of trades by insiders. Rules that require insidersto disclose their trades, either soon after the trade (as under current U.S.law) or perhaps even prior to trading, limit insider trading opportunities.

43

So do rules, or common practice driven by fear of liability, that restricttrading shortly before a major announcement, such as an earnings report.

e. Investment funds and pension funds. Investment funds and fundedprivate pension plans are indirectly useful institutions. These institutionsare natural investors in publicly traded securities. They dont directly con-trol self-dealing, but can provide demand for the market institutions thatconstrain self-dealing, as well as political support for the government insti-tutions that do so.

f. A strong bankruptcy system. For debt markets, an additional coreinstitution is a bankruptcy system that lets creditors recover most of a com-panys assets after it defaults. For equity markets, a bankruptcy system thatcontrols asset stripping is useful because it fosters an overall climate thatdiscourages self-dealing, but I dont view it as a core institution. Conversely,some institutions that are important in equity markets, notably those that

control insider trading, are less important for debt markets.g. A common law judicial system. Common law courts often have amore flexible decision-making style than civil law courts. That makes thembetter able to apply principles of fiduciary duty to sanction subtle forms offraud and self-dealing.

44Some developed civil law countries also have

reasonably flexible judging. But many suffer from overly formal judicial appli-cation of written rules.

43. See Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through

Pretrading Disclosure, 71 S. CAL. L. REV. 303 (1998).44. See John C. Coffee, Jr., Privatization and Corporate Governance: The Lessons from Securities

Market Failure, 25 J. CORP. L. 1 (1999a); Simon Johnson, Rafael La Porta, Florencio Lopez-de-Silanes & Andrei Shleifer, Tunnelling, AM. ECON. REV. (Papers and Proceedings), May 2000, at22; RAFAEL LA PORTA, FLORENCIO LOPEZ-DE-SILANES, ANDREI SHLEIFER & ROBERTW. VISHNY, INVESTOR PROTECTION: ORIGINS, CONSEQUENCES, REFORMS (Natl Bureau ofEcon. Research, Working Paper No. 7428, 2000), available at http://papers.ssrn.com/paper.taf?abstract_id=227587 (Social Science Research Network).


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816 48 UCLA LAW REVIEW 781 (2001)

III. PIGGYBACKING ON OTHER COUNTRIES INSTITUTIONSAn important question is to what extent can a company, located in

a country that lacks many of the institutions that control informationasymmetry and self-dealing, rely on other countries institutions. A relatedquestion: To what extent can an entire country adapt other countriesinstitutions for its own use? This part addresses that question. I use theterm piggybacking to refer to this process of using or adapting anothercountrys institutions.

Jack Coffee argues that individual companies can often piggyback onanother countrys institutions.

45Some piggybacking is surely feasible, but

Im more skeptical about its extent. Part A assesses the ease of piggybackingfor each core institution that I list in Part I (for information asymmetry),Part II (for self-dealing), or both. Part B discusses why its hard for compa-nies to develop and rely on substitute institutions.

A. Estimating the Ease of PiggybackingTable 1 below lists the core institutions that support strong securities

markets. It is organized to emphasize the overlap between the institutionsneeded to ensure good disclosure and those needed to control self-dealing.Table 1 also includes my rough judgments, on a 15 scale, for how easily acompany or an entire country can piggyback on foreign institutions. I explain

the rankings following the table. A rough translation of the 15 scale is:1: Significant piggybacking is not feasible.2: Piggybacking is very hard, will work poorly if attempted, or both.3: Piggybacking is hard, will work only moderately well if achieved,

or both.4: Piggybacking is feasible, not too hard, and likely to work rea-

sonably well.5: Piggybacking is easy (nearly as easy as for a company already

located in the foreign country).

The rankings are intended to move beyond general discussion ofwhether piggybacking is feasible, into detailed consideration of which insti-tutions can be piggybacked (and how effectively), which cant, and theobstacles to effective piggybacking. That, in turn, can inform a nationalreform strategy.

A key general theme that emerges from the rankings: Only a few insti-tutions are easily transplantable. The most basic institutionsincluding

45. See Coffee (1999), supra note 2.


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culture and honest, competent courts, regulators, and prosecutorsare thehardest to transplant. Thus, one cant transplant local enforcement.

Even if piggybacking is possible, it may not be attempted. Insidersof already public companies often wont want their company to provideadditional disclosur

11-05-11 black - the legal and institutional foundations for strong capital markets

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