The legal and institutional preconditions for strong securities market

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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 company’s business and (2) have confidencethat a company’s managers and controlling shareholders won’t 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, forcingfirms to rely on internal financing or bank financing—both 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 ...................................................................... 786B. The Core Institutions that Control

Information Asymmetry ................................................................................ 789C. Additional Useful and Specialized Institutions............................................. 799

1. Useful Institutions.................................................................................. 799

* I thank the Organisation for Economic Co-operation and Development (OECD) forfinancial 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 commentsand 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? ................................................................................................ 803II. PROTECTING MINORITY INVESTORS AGAINST SELF-DEALING.............................. 804

A. Self-Dealing as an AdverseSelection/Moral Hazard Problem .................................................................. 804

B. 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..................................... 832B. Empirical Evidence: Investor Protection and Strong

Capital Markets ............................................................................................. 834C. Empirical Evidence: Investor Protection, Capital Markets,

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

SEPARATING EQUILIBRIUM?................................................................................... 838VI. IMPLICATIONS ....................................................................................................... 841

A. Different Types of Monitoring: Investor Protectionand Firm Performance ................................................................................... 841

B. 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 andcreate stock markets overnight, in formerly centrally planned economieslike Russia and the Czech Republic, have crashed and burned.1 Investor-

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).

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 country’s laws and related institutions must give minor-ity shareholders: (1) good information about the value of a company’sbusiness; and (2) confidence that the company’s insiders (its managers andcontrolling shareholders) won’t 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 itdoesn’t significantly constrain the private contractual arrangements that a company’s 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 country’s rules. But only partial escape ispossible. A company’s reputation is strongly affected by the reputations ofother firms in the same country. And reputation unsupported by localenforcement and other local institutions isn’t nearly as valuable as the samereputation buttressed by those institutions.

I don’t address here a third aspect of corporate governance—how gooda country’s 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 don’t 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 don’tissue 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 doesn’t 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.


market-centered markets offer liquidity but weaker monitoring. I argue herethat stock-market-centered capital markets provide strong informationdisclosure and control of self-dealing—monitoring dimensions for whichbank-centered capital markets are often weaker.5 Moreover, the standarddebate 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 acute—a public offering of common shares, often bya 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 asymmetryis 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 INCOMPATIBILITY 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 OFFERINGS

A. 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 company’s sharesdepends on the company’s future prospects. The company’s past perform-ance is an important guide to future prospects. The company’s insiders knowabout both past performance and future prospects. They need to deliver thisinformation to investors so that investors can value the company’s shares.

Delivering information to investors is easy, but delivering credible infor-mation is hard. Insiders have an incentive to exaggerate the issuer’sperformance and prospects, and investors can’t 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 can’t rely on the company’s prior reputationto signal the quality of the information that it provides.

In economic jargon, securities markets are a vivid example of a marketfor lemons.6 Indeed, they are a far more vivid example than George Akerlof’soriginal 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, acompany’s 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 can’t directly verify.

Investors don’t 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. Butconsider the plight of an “honest” company—a company whose insiders reporttruthfully to investors and won’t divert the company’s 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).


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 won’t discourage dishonest issuers. Shares that aren’tworth the paper they’re printed on are, after all, quite cheap to produce. Thetendency for high-quality issuers to leave the market because they can’tobtain 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 intermediaries—accounting 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.7

But even in the United States, “securities fraud”—the effort to sellshares at an inflated price through false or misleading disclosure—is 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 createsan 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 thataccountants 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, 595–607 (1984).

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investor trust, because most investment bankers are honest and care abouttheir reputations. Investors (rationally) won’t fully investigate investmentbankers’ claims to have strong reputations. The other key intermediaries—accountants and securities lawyers—can similarly trade on their profession’sreputation (notwithstanding the occasional snide joke about whether thatreputation is deserved).

In the language of welfare economics, investment banking (or account-ing or securities lawyering) involves an externality—any one participantcan’t fully capture its own investment in reputation. Some of the invest-ment enhances the reputation of the entire profession. That externalityreduces incentives to invest in reputation. And new entrants can free rideon reputational spillover from established firms.

The combination of ability to free ride on other investment bankers’reputations and low entry barriers permits entrepreneurs—call them “bogusinvestment bankers”—to call themselves investment bankers, intending toprofit by pretending that their recommendation of a company’s shares hasvalue. In effect, bogus investment bankers steal some of the value of theircompetitors’ reputations, while also devaluing those reputations, becausebad reputations spill over to the rest of the profession just as good ones do.

The result is ironic: The principal role of reputational intermediaries isto vouch for disclosure quality and thereby reduce information asymmetryin securities markets. But information asymmetry in the market for reputa-tional intermediaries limits their ability to play this role.8

There are several nonexclusive solutions to this problem. One is second-tier reputational intermediaries, who vouch for the first-tier intermediaries.Voluntary self-regulatory organizations (SROs) can play this role. A somewhatstronger solution is mandatory self-regulatory organizations. In the UnitedStates, for example, investment bankers must belong to either the NewYork Stock Exchange or the National Association of Securities Dealers. Amember evicted by one is unlikely to be accepted by the other. Thus, amandatory SRO can put a misbehaving member out of business, not merelydeprive it of the reputational enhancement from voluntary membership.

8. From this perspective, stock exchanges play a surprisingly small information verifica-

tion role. Entry barriers are significant (though falling). Thus, exchanges shouldn’t face largeexternalities in vouching for company reputation. Yet in countries with strong securities markets,exchanges don’t look much beneath the surface of audited financial statements in decidingwhether to list a new company. Perhaps the constraints on misdisclosure imposed by other insti-tutions are sufficient so that investors rationally don’t put much weight on an exchange listing,and the exchanges respond to lack of investor demand by not closely examining new issuers. Thissuggests a business opportunity for the major world exchanges: Companies from countries withweak domestic institutions need reputational enhancement. Close exchange oversight could attractthose companies to major exchanges.


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 company’s 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 Asymmetry

Countries with strong securities markets have developed a numberof 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 orwholly 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 fraud—the company has reported sales or inventorythat don’t 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 thecompany’s 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 helps—professionalism 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 O’Brien & Young MooShin, Corporate Governance in Korea at the Millennium: Enhancing International Competitiveness,(Report to the Korean Ministry of Justice, 2000), 26 J. CORP. 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.


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.11

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 company’s records. Also, an individual investor won’t oftenincur the expense of a complex lawsuit to recover the investor’s small pri-vate loss. It’s important to have class actions or another way to combinemany individually small claims.12 Contingency 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, Putin’s 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 Taiwan’s substitute for a securities class action, seeLawrence S. Liu, Simulating Securities Class Actions: The Case in Taiwan, CORP. GOVERNANCE INT’L,Dec. 2000, at 4.

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Financial Disclosure

(4) Extensive financial disclosure, including independent audits of publiccompanies’ financial statements.

A stock market can’t thrive unless listed companies provide investorswith audited financial statements. The risk of fraudulent or seriously mis-leading financial statements is too great. Audited financial statements providea critical reality check.

Whether audited financial statements and other disclosure require-ments for public companies must be required by law or will emerge anyway,through a stock exchange rule or common practice, is an oft-debated questionthat I need not address here. This custom can emerge through stock exchangerule or common practice, as it did in the United States.13 But a mandatoryrule might speed up this process. The case for mandatory audits and com-pliance with a defined set of accounting rules becomes stronger, the weakera country’s reputational intermediaries (who can police the disclosure) anddisclosure culture are.14

(5) Accounting and auditing rules that address investors’ need for reliableinformation.

Good accounting rules should be designed to provide informationuseful to investors. This sounds obvious, but in many countries, accountingrules are designed as much to facilitate tax collection as to inform investorsabout value.15 The rules should facilitate comparing a company’s past per-formance with similar companies, both in the same country and interna-tionally, and should limit managers’ flexibility to choose among alternativeaccounting practices in order to make their firm appear more profitable.

13. See Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453 (1997); Marcel

Kahan, Some Problems with Stock Exchange-Based Securities Regulation: A Comment on Mahoney, 83VA. L. REV. 1509 (1997); cf. Brian Cheffins, Does Law Matter?: The Separation of Ownership andControl in the United Kingdom, 30 J. LEGAL STUD. (forthcoming 2001), available at http://papers.ssrn.com/paper.taf?abstract_id=245560 (Social Science Research Network) (discussing LondonStock Exchange disclosure rules, which often preceded statutory requirements).

14. For pieces of the mandatory disclosure debate, see FRANK H. EASTERBROOK & DANIELR. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 276–315 (1991); Anat R. Admati& Paul Pfleiderer, Forcing Firms to Talk: Financial Disclosure Regulation and Externalities, 13 REV.FIN. STUD. 479 (2000); John C. Coffee, Jr., Market Failure and the Economic Case for a MandatoryDisclosure System, 70 VA. L. REV. 717 (1984); Paul G. Mahoney, Mandatory Disclosure as a Solution toAgency Problems, 62 U. CHI. L. REV. 1047 (1995) and sources cited infra Part VI.B.

15. Russia, for example, has been unwilling to adopt International Accounting Standardsfor precisely this reason. See Interview with Sergey Shatalov, First Deputy Minister of Finance, inNo More Delays, in the Move to IAS, ACCT. REP. (Int’l Ctr. for Accounting Reform, Moscow),Jan.–Feb. 2000, at 1 (Deputy Minister Shatalov complains that International Accounting Standards“do not specify in detail individual transactions . . . and the way to account for them for taxpurposes”).


Stricter rules aren’t 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 elsewhere—in 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, ratherthan a government agency. If the rule-writing body is private, its funding andthe manner of choosing its members must ensure that the agency isn’t 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 372–420 (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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art. With the twist that the artist’s task is to paint an accurate picture,while the subject pays the artist’s fee, often tries to persuade the artist that amore flattering portrait is a true one, and can replace an artist who paintstoo unflattering a portrait. Moreover, a minority of subjects are crooks whowill do whatever they can to mislead the artist and thus the investors whowill later view the portrait.

Professionalism is essential—to see the truth that the subject may try toconceal and to resist the subject’s pressure for an overly flattering portrait—if the portrait is to resemble reality and be comparable to other portraitspainted by other artists.

(8) Securities or other laws that impose on accountants enough risk of liabil-ity to investors if the accountants endorse false or misleading financial statementsso that the accountants will resist their clients’ pressure for laxer audits or morefavorable disclosure.

Accountants are reputational intermediaries. When they audit andapprove financial statements, they also rent out their reputations for con-ducting a careful audit that can catch some fraud and discourage attemptsat fraud, and for painting a tolerably accurate picture of a company’sperformance.

Liability risk reinforces the accounting firm’s concern for reputation.It can persuade the firm to establish internal procedures to ensure that thefinancial statements that it approves meet minimum quality standards. Liabil-ity risk also provides a compelling response to a client that wants a less intru-sive audit or more favorable accounting treatment than the accounting firmproposes.

The liability risk doesn’t have to be great. Frequent, American-style liti-gation isn’t needed. Perhaps a few lawsuits per decade, a couple of whichresult in a significant payout (in settlement or after a verdict), are enough.But without any liability risk, accounting firm partners will sometimes acceptthe ever-present temptation to squander the firm’s reputation to gain orkeep a client.18

18. A recent Russian example involves an audit by a “big-five” accounting firm of a major

Russian oil company. The company was (notoriously) selling oil to its majority shareholder atbelow-market prices, thus transferring profits from the company to the controlling shareholder.These transactions violated Russian company law, which required the company’s minority share-holders to approve these self-dealing transactions. A footnote to the company’s 1997 financialstatements disclosed mildly that these transactions “may” give rise to some liability by the controllingshareholder to the company, with no mention of the amount (which was in the hundreds ofmillions of dollars). A reputable accounting firm would never bless this paltry disclosure if it facedmeaningful liability to investors.


(9) A sophisticated investment banking profession that investigates securitiesissuers because the investment banker’s 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 issuer’s prospects, the major risks of the investmentare disclosed, and the issuer’s 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 bank’s 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 firm’s reputation to gain a client and a fee.

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

Securities lawyers are a third major reputational intermediary—albeitless 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 lawyers’caution (deriving from the need to protect one’s 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.19

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 company’s reputation for honestdisclosure. But some of the time, the company needs funds now, or therewon’t 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 therewon’t be a next round in which the cheating can be punished.20 At othertimes, 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).


at risk, even if the company’s solvency is secure. Moreover, some con art-ists will happily take whatever money they can raise this time, and thenhope to sell another company’s shares the next time.

Insiders’ incentives to puff their company’s prospects help to explainthe universal use in public offerings of reputational intermediaries, whoinvestigate and vouch for the company’s disclosure. Just as liability toinvestors helps to ensure that reputational intermediaries behave as they aresupposed to, this liability helps to ensure that insiders disclose honestly inthe first place.

(14) Criminal liability for insiders who intentionally mislead investors.For insiders, unlike reputational intermediaries, financial liability

alone is not a sufficient deterrent. Insiders often have little wealth outsidetheir firm or can hide much of their wealth out of investors’ reach. Moreover,the prospect of disgorging one’s ill-gotten gains, with probability less thanone, won’t adequately deter crooks from attempting fraud in the firstinstance. That makes criminal sanctions a critical supplement to financialliability. At the same time, formal criminal sanctions are of little valuewithout skilled prosecutors who can bring complex securities cases.

Market Transparency

(15) Rules ensuring market “transparency”: the time, quantity, and priceof trades in public securities must be promptly disclosed to investors.

One key source of information about value that investors rely on is theprices paid by other investors for the same securities. Investors then knowthat others share their opinions about value. Transparency is a collectivegood that must be established by regulation. Large investors prefer to hidetheir transactions to reduce the price impact that their trades have. Some-times a stock exchange will have enough market power to force all trades tobe reported to it. More commonly, the government must mandate promptreporting and require all trades to be reported in a single consolidatedsource, lest exchanges compete for business by offering delayed or no pricereporting.21

21. For an effort to model the instability of market transparency, see Robert Bloomfield &

Maureen O’Hara, Can Transparent Markets Survive?, 55 J. FIN. ECON. 425 (2000). A technologi-cal alternative to consolidated reporting could work for larger investors: Private providers cancollect prices from multiple exchanges and sell consolidated reports to investors. As more compa-nies choose to be listed on multiple exchanges in different countries, the private solution maydominate the regulatory solution of consolidated reporting (which can’t cross borders as easily).But private providers can only report trades that the exchanges report to them, so prompt report-ing must still be mandated.

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

Transparent market prices raise their own dangers. Especially in “thin”markets, insiders can manipulate trading prices to create the appearancethat a company’s 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 canuncover 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 won’t 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 analyst’s 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 Prohibit“Manipulation” in Financial Markets?, 105 HARV. L. REV. 503 (1991); Steve Thel, $850,000 in SixMinutes—the 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 ofdepressing 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 Body’s 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.


say nasty things about a client or potential client—in 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.24

(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 therules—both direct public enforcement and indirect enforcement throughprivate institutions, especially reputational intermediaries.

C. Additional Useful and Specialized Institutions

The list of core institutions in Part B reflects my personal judgmentabout which rules and institutions are most important for ensuring gooddisclosure. This part lists some additional institutions that I consider usefulbut not core.

1. Useful Institutions

a. Licensing of reputational intermediaries. It’s useful for accountantsand investment bankers to be subject to a regulatory licensing scheme. Idon’t 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. See The 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.25

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 SRO’s 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 isn’t 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 disclosureproblems 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 shouldn’t 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 someprotection 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 1929–43.


rities market by providing a source of investable funds, as well as market andpolitical demand for strong disclosure. I don’t 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 fund’s 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 (Russia’s, 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 won’toverride 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 Institutions

For 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 severeinformation asymmetry problems, because these companies often haveshort histories, make highly specialized products, participate in fast-moving

26. See COFFEE (2001), supra note 19 (discussing Germany’s 1896 stamp tax); cf. Christopher

J. 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, 24J. 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 specializedinstitution—the venture capital fund—that 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 don’t see.27

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 started—a venture capitalist can’t getfunding until he develops a reputation for making good investments, butcan’t 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 Moody’s and Standard & Poor’s 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 VentureCapital, 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).


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 theadditional core institutions for controlling self-dealing discussed in Part II,raise an obvious question: Which institutions are really necessary, andwhich 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 didn’t 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.29

The interrelationships among institutions—complements in somerespects, substitutes in others—mean 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.30 That suggests that such a ban is important enough to beconsidered 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 can’t prove this, but neither can Ithink of any counterexamples.

II. PROTECTING MINORITY INVESTORS AGAINST SELF-DEALING

A. 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 forthemselves—for 50 percent of the voting shares (less if the remainder arediffusely held) to convey most or all of the company’s 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 company’s 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 insidertrading. First, it’s 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 can’t producesimilar gains. For one thing, insider trading in significant volume requires aliquid stock market, which countries that don’t control direct self-dealingwon’t have. For another, long-term buy-and-hold investors aren’t directlyharmed by insider trading. You can only be on the losing side of a tradewith an insider if you’re 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 isn’t true. A country can controldirect 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 don’t know which insidersare honest and which will appropriate most of the company’s value, so they


discount all companies’ share prices. This creates a dilemma for honestinsiders who won’t divert the company’s income stream to themselves.Discounted share prices mean that a company with honest insiders can’treceive fair value for its shares. This gives the company an incentive to useother forms of financing. But discounted prices won’t 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 can’t 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 sharescan’t 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 company’s value than investors expected when they bought theshares. Again, insurance terminology is helpful—the incentive to renege isknown 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.31

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 similartriggering 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 166–204 (1992).

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self-dealing, and securities lawyers can play a role if they prepare the com-pany’s 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 company’s 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 don’t knowthe company’s 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 $125.32

If the insiders keep only 50 percent of the company’s value, they havecheated themselves. Their shares will be worth only $62.50, while the out-side investors’ shares will be worth $62.50—far 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 company’s value.

But in opposing reforms, insiders of already public companies reinforcea system that won’t prevent them from taking more than 80 percent of thecompany’s value if they choose—and 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 company’s 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 tocounter information asymmetry, they have developed institutions tocounter 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 657–59.


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.33 Rules 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 won’t 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 won’t 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 can’t 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-tion’s 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 preventthis 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 1932–34, 1958–60.


mine how much to trust the insiders and enhance the insiders’ incentive todevelop reputations for not abusing their power.

(7) A good overall financial disclosure regime.Good overall financial disclosure makes it harder to hide direct self-

dealing. Moreover, the better the information that the public has, the smallerthe profit opportunity from insider trading.

Reputational Intermediaries

(8) Requirements that a company’s accountants review self-dealing trans-actions and report on whether they were accurately disclosed.

Insiders have a powerful incentive to hide self-dealing, despite formaldisclosure obligations. Unlike the situation when a company issues sharesto investors, there is no direct way for investors to insist that reputationalintermediaries review self-dealing transactions. Accountants are the obviousintermediary that can play this role. Accountant review of self-dealing trans-actions can emerge by law or by custom. But unless mandated, it will beopposed by already public companies, and isn’t likely to emerge quickly.

If accountants review self-dealing disclosure, we will also need:(9) A sophisticated accounting profession with the skill and experience to

catch some nondisclosed self-dealing transactions and insist on proper disclosure.Insiders who are determined to self-deal can sometimes do so even

with an accountant looking over their shoulders. The insiders can disguisea transaction, or their interest in the transaction, by running one or boththrough multiple intermediaries. Thus, accountants must be sophisticatedenough, and auditing standards rigorous enough, to catch at least some ofthe subterfuges.

Accountants can’t catch every instance of self-dealing. It would costtoo much for them to investigate every transaction. But this practical limitonly reinforces the need for skilled accountants who know which closetsthe insiders are most likely to hide skeletons in, so the accountants can makegood use of their limited resources.

To ensure that the accountants do a good job, we will also need:(10) Securities or other laws that impose on accountants enough risk of

liability to investors, if the accountants endorse false or misleading disclosure ofself-dealing transactions, so that the accountants will search vigorously and resisttheir clients’ entreaties to let them hide or mischaracterize self-dealing transactions.

The reasons for liability risk are the same as for information asymmetrygenerally. The accountants are hired and paid by the company. They inevi-tably face pressure to overlook suspicious closets, accept dubious transac-tions at face value, or accept incomplete disclosure of an admitted self-dealing

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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 counsel’s 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 directors’personal liability if they don’t behave independently is a central support forthis constraint. Company liability can help to persuade the independentdirectors to reject transactions that aren’t on arms-length terms. Liabilityalso 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 whenthey 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-


cipal civil sanction is liability to shareholders; regulators can also enjoinfuture violations or bar offending insiders from being principals of publiccompanies.

(14) Criminal liability for insiders who intentionally violate the self-dealingrules.

Return of ill-gotten gains is an insufficient remedy as long as insiderscan hide or spend most of their gains, especially because the probability ofdetection is less than one. Damages equal to a multiple of the insider’s gainsare of limited effectiveness given limited insider wealth and the insiders’ability to hide much of that wealth. Thus, criminal sanctions, enforced by aspecialized prosecutor, are an essential supplement to civil liability.

Institutions to Control Insider Trading

I have thus far focused on the institutions needed to control direct self-dealing. I list next the additional core institutions that are needed to con-trol insider trading.

(15) Securities or other laws that prohibit insider trading, suitably defined,and government enforcement of those rules.

To be effective, a ban on insider trading must include a ban on tippingothers, as well as on trading yourself. The rules must be enforced, lest insid-ers learn that they can violate the rules with impunity.35

(16) A stock exchange with meaningful listing standards, the willingness tofine or delist companies that violate the self-dealing rules, and the resources to runa surveillance operation that can catch some insider trading.

For direct self-dealing, stock exchange enforcement, through fines anddelisting (or the threat of delisting), is an important supplement to officialenforcement. For insider trading, the stock exchange is the institution thatis best able to monitor its own trading, looking for unusual patterns thatsuggest insider trading. But running a good insider trading surveillance pro-gram isn’t cheap. The New York Stock Exchange alone will spend $95million this year on market surveillance, mostly aimed at controlling insidertrading.36

35. See BHATTACHARYA & DAOUK (1999), supra note 30 (reporting that (1) many coun-

tries have bans on insider trading that are never enforced, (2) enforced insider trading rules have ameasurable effect on share prices, which they estimate at 5 percent, and (3) unenforced rules haveno significant effect on share prices).

36. See E-mail from George Sofianos of the New York Stock Exchange, to Bernard Black(July 27, 2000); see also Cheffins (2001), supra note 13 (noting that the London Stock Exchangemounts over 100 major insider trading investigations annually and refers 30–40 cases annually forpossible criminal prosecution).

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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.37

(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 termsabout 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.


ing a seriously unfair transaction, or trading on inside information is improper anda recipe for trouble.

In countries with strong securities markets, the sanctions against directand indirect self-dealing are strong enough to reinforce a norm against thisconduct. That culture reduces the frequency of self-dealing and improvesthe quality of the transactions that occur. Like the related norms support-ing good disclosure and establishing value maximization as a managerialgoal, the norm and the supporting institutions likely develop together andreinforce each other.38

To take a recent Russian example, it would never occur to an Ameri-can oil company’s managers to propose (as Russian oil company Yukos didin 1999) that the company sell its oil to unknown offshore companies for$1.30 per barrel when the market price was $13. The managers wouldn’tpropose this, the independent directors wouldn’t approve it, and if it some-how occurred anyway, the press would report the scandal, and the managerswould face both civil and possible criminal liability. In Russia, the pressreported some of the scandal, but the managers went ahead anyway.39

This list suggests the difficult task facing a country that wants to con-trol self-dealing. Once again, rules on paper are necessary but not suffi-cient. Enforcement is critical. Russia offers a good example. The Russiancompany law contains reasonably strong procedural protections against self-dealing transactions. But Russian companies routinely ignore the rulesbecause they aren’t enforced. Insiders hide self-dealing transactions, and(sometimes corrupt) prosecutors and judges usually let the insiders off thehook in the rare case when a transaction is exposed. Reputationalintermediaries—including major investment banks and accounting firms—don’t face appreciable liability risk and sometimes choose to look the otherway and accommodate a major client, in ways they would never dream of intheir home countries.40

38. For discussion of the interplay between legal requirements and the U.S. social norm

against self-dealing, see Melvin A. Eisenberg, Corporate Law and Social Norms, 99 COLUM. L. REV.1253, 1271–78 (1999). For discussion of why the trustworthiness of corporate actors dependson the social context in which they operate, see Margaret M. Blair & Lynn A. Stout, Trust, Trust-worthiness, and the Behavioral Foundations of Corporate Law, 149 U. PA. L. REV. (forthcoming2001), available at http://papers.ssrn.com/paper.taf?abstract_id=241403 (Social Science ResearchNetwork).

39. For more details, see Black, Kraakman & Tarassova (2000), supra note 1.40. A Russian example: Goldman Sachs’ courting of Yukos and its controlling shareholder,

Mikhail Khodorkovski, despite warning signs that Khodorkovski was a crook and that a majorbank loan, syndicated by Goldman, was supported by guarantees from Yukos subsidiaries that wereillegal under Russian company law. Goldman executives later told the New York Times that theythought Yukos acted legally under Russian law. My personal belief is that, with an eight-digit fee

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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 don’t 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 Institutions

The list of core institutions in Part B reflects my personal judgmentabout 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 aper 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 company’s current controlling shareholders, theyhave an assured exit, at a reasonable price, if control changes hands.42

in prospect, Goldman Sachs didn’t want to know otherwise. See Joseph Kahn & TimothyO’Brien, For Russia and Its U.S. Bankers, Match Wasn’t 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 andAgency 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”).


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 don’t 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-pany’s 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 don’t view it as a core institution. Conversely,some institutions that are important in equity markets, notably those thatcontrol 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.44 Some developed civil law countries also havereasonably 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 (Nat’l 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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III. PIGGYBACKING ON OTHER COUNTRIES’ INSTITUTIONS

An important question is to what extent can a company, located ina 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 countries’institutions for its own use? This part addresses that question. I use theterm “piggybacking” to refer to this process of using or adapting anothercountry’s institutions.

Jack Coffee argues that individual companies can often piggyback onanother country’s institutions.45 Some piggybacking is surely feasible, butI’m 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 it’s hard for compa-nies to develop and rely on substitute institutions.

A. Estimating the Ease of Piggybacking

Table 1 below lists the core institutions that support strong securitiesmarkets. 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 1–5 scale, for how easily acompany or an entire country can piggyback on foreign institutions. I explainthe rankings following the table. A rough translation of the 1–5 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 can’t, 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 institutions—including

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


culture and honest, competent courts, regulators, and prosecutors—are thehardest to transplant. Thus, one can’t transplant local enforcement.

Even if piggybacking is possible, it may not be attempted. Insidersof already public companies often won’t want their company to provideadditional disclosure of management compensation or self-dealing transac-tions, or otherwise strengthen controls on self-dealing. They often alsooppose their country’s efforts to piggyback on strong institutions in othercountries.46

Table 1Estimated Ease of Piggybacking on Foreign Institutions

Needed for: Piggybacking Ease:Core Institutions Information

DisclosureSelf-

Dealingfor a

Companyfor a

Country

Local Enforcement and Culture

1. An honest, sophisticatedsecurities agency (and prosecu-tors for criminal cases).

X X 1 1

2. Honest, sophisticated, well-functioning courts. X X 1 1

3. Good civil discovery rulesand a class action or similarprocedure.

X X 1 2

4. A culture of compliance withdisclosure and self-dealing rulesby insiders, reputational interme-diaries, and independent direc-tors.

X X 2 1

46. For examples of this political opposition, see Amir N. Licht, David’s Dilemma: A Case

Study of Securities Regulation in a Small Open Market, 3 THEORETICAL INQUIRIES L. (forthcoming2001) (noting that many Israeli companies that list on NASDAQ have opted for the more relaxeddisclosure (principally of self-dealing transactions) available to foreign issuers under U.S. rules, andoppose domestic rules that would require additional disclosure of these transactions); Black,Metzger, O’Brien & Shin (2001), supra note 10 (discussing South Korea); and Bernard S. Black,Strengthening Brazil’s Securities Markets, REVISTA DE DIREITO MERCANTIL, ECONOMICOE FINANCIERO (J. COMMERCIAL, ECON. & FIN. L.) (forthcoming 2001), available at http://papers.ssrn.com/paper.taf?abstract_id=247673 (Social Science Research Network) (discussingBrazilian reform efforts).

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DisclosureSelf-

Dealingfor a

Companyfor a

Country

Disclosure Rules

5. Rules requiring full disclo-sure of financial results and self-dealing transactions.

X X 4 3

6. Good accounting and auditingrules. X X 4 3

7. Requirements for auditedfinancial statements. X X 4 3

8. Ownership disclosure rules. X 4 3

Reputational Intermediaries and Independent Directors

9. A sophisticated accountingprofession. X X 4 2

10. A sophisticated investmentbanking profession. X 4 2

11. Sophisticated securities law-yers. X X 4 2

12. A stock exchange withmeaningful listing standards andan active insider trading surveil-lance operation.

X X 5 3

13. Inclusion of independentdirectors on company boards. X 3 2

Liability

14. Civil liability for insiderswho violate the disclosure andself-dealing rules.

X X 2 1

15. Criminal liability for insiderswho intentionally violate thedisclosure and self-dealing rules.

X X 1 1

16. Civil liability risk foraccountants. X X 3 2



DisclosureSelf-

Dealingfor a

Companyfor a

Country

17. Civil liability risk for invest-ment bankers. X 3 2

18. Civil liability risk for inde-pendent directors who approvegross self-dealing.

X 2 1

Market Transparency

19. Transparency of trading prices. X X 4 3

20. An enforced ban on marketmanipulation. X X 3 2

Self-Dealing Rules

21. Procedural controls on self-dealing transactions (review byindependent directors, nonin-terested shareholders, or both).

X 4 3

22. Accountant review of thedisclosure of self-dealing trans-actions.

X 4 2

23. Enforced securities or otherrules banning insider trading. X 3 2

Other Institutions

24. An active financial pressand security analysis profession. X X 3 2

25. A good organization to writeaccounting rules. X X 5 3

Mean ranking: 3.12 2.12

A company’s promise to obey another country’s tougher rules—bondedby listing on a foreign stock exchange and hiring world-class accountants,investment bankers, and lawyers—has substantial value.47 Firms can further

47. On the valuation effects for foreign companies that list their shares in the UnitedStates, see Vihang R. Errunza & Darius P. Miller, Market Segmentation and the Cost of Capital inInternational Equity Markets, 35 J. FIN. & QUANTITATIVE ANALYSIS 577 (2000); and Darius P.

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enhance their own reputations over time, by promising to obey foreign rulesand then keeping that promise. But weak local enforcement and culturewill still lead investors to discount the company’s promises. Moreover, inmany countries, only the largest companies can afford to hire world-classaccountants, bankers, and lawyers.

Consider Vimpelcom—a Russian telephone company that went publicin the United States, is listed on the New York Stock Exchange, has mostof its shareholders in the United States, and has made itself subject to U.S.accounting requirements and securities laws. That effort helps Vimpelcom’sshares to trade at a higher multiple of earnings than a comparable Russiancompany, traded in the Russian stock market, that follows domestic rules.But investors still heavily discount Vimpelcom’s shares compared to anAmerican company with the same prospects because they know thatVimpelcom’s insiders can cheat and get away with it.

Vimpelcom could potentially bind itself in its charter more tightlythan Russian law requires. But investors won’t fully trust an untested char-ter provision, especially one that must be enforced in unreliable Russiancourts. For example, another major Russian company, Noyabrskneftegaz,recently ignored a charter provision that granted preemptive rights toshareholders, and instead sold shares cheaply to insiders. The resultinglawsuit by minority shareholders found an unfriendly reception in theRussian courts and has been abandoned.48 And no charter provision canstop the Russian government from again—as it recently did—simply takingcore assets from Vimpelcom (in this case, part of the frequency spectrumthat Vimpelcom thought it owned).49

The strategy of listing shares overseas is also subject to domestic poli-tics. Countries can restrict foreign ownership or foreign share trading. Forexample, investors who bought shares of Malaysian companies on theSingapore stock exchange were unhappily surprised in 1998, when theMalaysian government declared these shares untradeable. Some Malaysiancompanies then proved their own untrustworthiness by offering to buy thefrozen shares back from investors at a steep discount to market.50

Miller, The Market Reaction to International Cross-Listings: Evidence from Depositary Receipts, 51 J.FIN. ECON. 103 (1999).

48. See Bernard Black, Shareholder Robbery, Russian Style, ISSUE ALERT (InstitutionalShareholder Servs.), Oct. 1998, at 3.

49. See A Phone Farce in Russia, ECONOMIST, Sept. 16, 2000, at 68.50. See Malaysia’s Stockmarket: Daylight Clobbery, ECONOMIST, July 10, 1999, at 71; Raphael

Pura, Turmoil Grows Over Fate of Frozen Malaysian Shares, WALL ST. J., Dec. 31, 1999, at A6.


A second general theme: An individual company can borrow a rea-sonable number of institutions from abroad. In seventeen of the twenty-fivecategories, I assess piggybacking potential for an individual company at 3or above. The mean ranking is 3.16. Table 2 provides some simple statistics.

Table 2Company Rankings for Ease of Piggybacking

Ranking Frequency1 42 33 54 115 2

Mean: 3.16

Third, it’s much harder for an entire country, and thus for smallerfirms, to piggyback on foreign institutions than for a single major firm to doso. For example, a single major firm can adopt international accountingstandards, albeit with some expense and some reduced comparability withother firms in its home country. However, an entire country’s ability toadopt complex international rules is limited by the sophistication of localaccountants and by the extent to which local laws are tied to the oldaccounting rules, in which case the laws must be changed as well.

Table 3 summarizes the country rankings. No institution receives a 4or a 5 ranking, and seventeen of the twenty-five institutions receive a rank-ing of 1 or 2. The mean country ranking of 2.12 is over a full point lowerthan the mean company ranking of 3.16.

Table 3Country Rankings for Ease of Piggybacking

Ranking Frequency1 62 113 84 05 0

Mean: 2.12

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Fourth, in the detailed analysis of piggybacking potential that follows,local enforcement and local culture emerge over and over again as key obsta-cles to the ability of a company or an entire country to piggyback on foreigninstitutions.

The reasoning underlying these rankings follows. Almost every readerwill likely disagree with me on some of the rankings. I’ve waffled back andforth on some myself. Yet, as a whole, I think the rankings paint a reason-able picture of the possibility and limits of piggybacking.

Local Enforcement and Culture

(1) An honest, sophisticated securities agency, and prosecutors for criminalcases (company ranking = 1, country ranking = 1).

(2) Honest, sophisticated, well-functioning courts (company ranking = 1,country ranking = 1).

These institutions are at the heart of a good national investor protec-tion system, and are neither transplantable nor easily created.

(3) Good civil discovery rules and a class action or similar procedure(company ranking = 1, country ranking = 2).

A precondition for effective enforcement of liability rules is good civildiscovery rules. A class action or other procedure that lets individual inves-tors aggregate their claims is important too. In practice, borrowing theserules has proven much harder in many countries than borrowing substan-tive shareholder protection rules. This is partly because discovery rules andclass actions implicate the entire civil justice system, and partly becauseregulators with jurisdiction over company or securities law often have nojurisdiction over procedural rules.51

This is the only institution for which the country ranking exceeds thecompany ranking. A country can try to adapt foreign discovery and classaction rules, but an individual company is bound by its country’s rules.

(4) A culture of compliance with disclosure and self-dealing rules by insid-ers, reputational intermediaries, and independent directors (company ranking =2, country ranking = 1).

Culture is inherently local. A single company can take some steps toimport a culture of compliance with disclosure and self-dealing rules. It can

51. For example, during recent (1999–2000) advice on corporate governance reform to the

South Korean government, the Ministry of Justice advised us that adopting a class action proce-dure was simply not possible, no matter how strongly it might be needed. Such a procedure hadbeen recently rejected by the legislature, and reraising the issue was deemed not to be politicallyviable.


hire foreigners to sit on its board of directors and to work in its financialdepartment. That helps, but only so much. The bulk of the staff will belocal and can hide local skeletons from the foreigners. And the locals’thought processes, as they consider engaging in self-dealing or disclosingsomething they’d rather hide, will be influenced primarily by national cul-ture and expectations, even if their company tries to instill different norms.52

Disclosure Rules

(5) Rules requiring full disclosure of financial results and self-dealing trans-actions (company ranking = 4, country ranking = 3).

A single company can, without great difficulty, list on the New YorkStock Exchange or NASDAQ (say) and subject itself to U.S. disclosure andaccounting rules. The company still may not follow the disclosure rules asattentively as an American company, nor as honestly if the company getsinto financial trouble and the insiders face a final period problem. Hencethe company ranking of 4 instead of 5.

It’s much harder for a whole country to borrow disclosure rules. Forexample, American securities laws can’t be simply copied and transplantedwholesale to another country. They won’t mesh with other local institu-tions, will likely conflict with other local laws, will be far more complexthan needed, and will in some respects be weaker than needed, because offi-cial rules can be less strict when informal enforcement is strong. Effectiveborrowing of disclosure rules from abroad requires close collaborationbetween domestic draftsmen and foreign experts. The end product will inevi-tably be imperfect before it gets to the legislature, and still more imperfect(perhaps much more so) when it emerges from the legislature. Thus, thetransplantability of a whole body of law warrants a 3 ranking at best.

(6) Good accounting and auditing rules (company ranking = 4, countryranking = 3).

(7) Requirements for audited financial statements (company ranking = 4,country ranking = 3).

52. Compare, for example, Korea and Russia. Korea has no shortage of self-dealing, but

enjoys an underlying culture of honest business dealings that is far stronger than Russia’s. Thefounders of the chaebol (Korean conglomerates) are wealthy but not unseemly so; related partytransactions within a corporate group are more often intended to prop up losing companies thanto enrich the founding family. In contrast, while Russian businessmen often treat each other hon-estly, many think of foreign investors as sheep to be fleeced. This attitude has caused many Russian-foreign joint ventures to founder. Few new ones are currently being started because the pasthistory is so bad.

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Audit requirements and accounting rules are not too hard for a com-pany to borrow from abroad. The rules exist in reasonably clear form—themost common choices are U.S. General Accepted Accounting Principles orInternational Accounting Standards. At some extra cost, a company cankeep two sets of accounts, one following local rules and the second follow-ing international rules, and can hire an international accounting firm toaudit its financial statements. Weak local enforcement will still limit thecredibility of the financial statements. Extra cost, lack of local enforcement,and reduced comparability with other domestic companies explain whythese institutions receive a 4 rather than a 5 ranking.

Transplanting accounting rules and audit requirements is harder for acountry than for a single company. A country can adopt foreign accountingrules and audit requirements, but local accountants must implement theserules. The lower country ranking of 3 blends the 4 ranking for an individ-ual company with the 2 ranking for transplanting a sophisticated account-ing profession.

(8) Ownership disclosure rules (company ranking = 4, country ranking= 3).

The analysis here is much the same as for disclosure rules generally. Asingle company can list on a foreign stock exchange and subject itself to theexchange’s disclosure rules. The company and its insiders still may not followthe rules as attentively as they might if there were serious sanctions formisdisclosure. Hence the company ranking of 4.

A country’s ownership disclosure rules must fit into its overall legalframework. For example, if courts don’t see immediately that if CompanyA controls Company B, which controls Company C, then Company A alsocontrols Company C, then disclosure rules that work fine in a developedcountry will break down. The country ranking of 3 reflects this risk.53

Reputational Intermediaries and Independent Directors

(9) A sophisticated accounting profession (company ranking = 4, countryranking = 2).

(10) A sophisticated investment banking profession (company ranking =4, country ranking = 2).

53. In Russia, for example, it’s an open issue under the company law whether, if Company C

is a subsidiary of Company B, and Company B is a subsidiary of Company A, that makes Company Ca subsidiary of Company A. This affects, among other things, whether a transaction between C andA is governed by the rules that require noninterested shareholders to approve related-party transactions.


(11) Sophisticated securities lawyers (company ranking = 4, countryranking = 2).

A major company can hire international accountants, investmentbankers, and lawyers. This isn’t cheap, but can produce reasonably effectivereputational intermediation. Investors will have less confidence in the inter-mediaries’ recommendations than in a country with good local enforcementand culture, hence the company ranking of 4.

A country can do a little bit to piggyback on the existence of interna-tional accounting, investment banking, and law firms. It can permit themto enter, compete with local firms, and hire local people, some of whom willlater join or start local firms. But building a sophisticated local profession is adecades-long task. Doing so requires strong university-level education, andalso requires a capital market to develop that creates the demand for theseprofessionals and leads talented young people to choose these professions.That merits a country ranking of 2.

(12) A stock exchange with meaningful listing standards and an activeinsider trading surveillance operation (company ranking = 5, country ranking= 3).

An individual company can list its shares on a foreign exchange andobtain most of the reputational benefits from doing so. Hence the rarecompany ranking of 5. A caveat: Some stock exchanges try to attract for-eign listings by offering reduced listing standards. The New York StockExchange, for example, has long wanted to accept less financial disclosurethan the United States Securities and Exchange Commission is willing toaccept. If an exchange attracts listings by lowering its standards, the reputa-tional benefits of listing decline as well.

A country that wants to build a stock exchange can import listing rulesand trading systems, though both will need to be adapted to local needs.Another strategy, unpopular so far, is to build no stock exchange at all andexpect local firms to list abroad, perhaps on a regional exchange. Theseoptions make stock exchanges easier to borrow than other reputationalintermediaries, which warrants a country ranking of 3.54

54. For example, the Sao Paolo stock exchange, known as Bovespa, is planning to create a

second market with tough listing rules, patterned on the Frankfurt Neuer Markt. Because the newtough rules apply only to companies that choose to list on this new exchange, this approach side-steps political opposition from already public companies to curbs on self-dealing. On the NeuerMarkt’s rules, see Vanessa Fuhrmans, Playing by the Rules: How the Neuer Markt Gets Respect,WALL ST. J., Aug. 23, 2000, at C1.

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(13) Inclusion of independent directors on company boards (companyranking = 4, country ranking = 2).

A single company can appoint truly independent directors, includingforeign directors. But local directors’ actions will still depend partly onlocal culture and on the behavior of other directors in the same country.Foreign directors bring their culture with them, but may be hard to recruitbecause of language barriers and geographic distance, and will be lessinformed and less effective because they’re not embedded in the local envi-ronment. Hence the company ranking of 4.

A country can require companies to have a minimum number ofindependent directors as a way to promote independent director review ofself-dealing transactions, but it can’t do much to make the directors trulyindependent. Hence the lower country ranking of 2.

Liability

(14) Civil liability for insiders who violate the disclosure and self-dealingrules (company ranking = 2, country ranking = 1).

A company can’t do much to import civil liability for insiders. Its for-eign assets are vulnerable to a suit in a foreign country. The company canbe delisted from a foreign exchange if it misbehaves. But these exposuresare limited and affect insiders only indirectly through the shares they own.Only the insiders’ home country offers civil claims against personal assets.In practice, cases in which foreign investors have obtained damages fromlocals in institutionally challenged countries, even for egregious behavior,are rare. Most investors don’t even try.55 Still, the insiders’ indirect expo-sure to foreign liability warrants a company ranking of 2.

Countries have an even harder time importing strong sanctions.Liability rules must fit within an existing legal framework. They can’t beimported wholesale. Moreover, good rules aren’t worth much without localenforcement.

(15) Criminal liability for insiders who intentionally violate the disclosureand self-dealing rules (company ranking =1, country ranking = 1).

Most countries impose criminal sanctions on corporate crooks, butenforcing these sanctions requires local discovery, local courts, and localprosecutors. These can’t be imported. Moreover, criminal rules must fitwithin an existing legal framework. They can’t be imported wholesale, theway that accounting or disclosure rules can be.

55. In Russia, for example, courts routinely refuse to enforce international arbitration

awards and sometimes reject claims by foreign creditors on peculiar grounds.


(16) Civil liability risk for accountants (company ranking = 3, countryranking = 2).

(17) Civil liability risk for investment bankers (company ranking = 3,country ranking = 2).

A company can offer shares overseas, subject to overseas rules, usinginternational accountants and investment bankers. It will thereby subjectthe accountants and bankers to foreign as well as local liability. But proofproblems can be severe. Intermediaries are typically liable only if theirconduct is culpable—whether the degree of culpability is negligence, grossnegligence, recklessness, or something else. Proving culpability requireslocal facts, which are often hard to uncover. Thus, in practice, weak localenforcement greatly reduces the liability faced by reputational intermediar-ies. Hence the company ranking of 3.

A country that wants to create liability for reputational intermediarieswill often need to change not only its substantive rules, but its proceduralrules as well, so that small investors can aggregate their claims. And localenforcement is still hostage to the strength of local courts. Moreover, theintermediaries will oppose strong local liability rules. Internationallyknown intermediaries will fear that liability judgments may reflect home-court bias, corruption, or a desire to compensate local investors at theexpense of deep-pocketed foreigners. Those worries can only be assuagedby strong local courts and experience over time. Until then, strong liabilityrules may scare away world-class intermediaries, instead of prompting themto be more careful. Hence the country ranking of 2.

(18) Civil liability risk for independent directors who approve gross self-dealing (company ranking = 2, country ranking = 1).

Independent directors will generally be locals and hold their assetslocally. In practice, they will be liable (if at all) only under local law. Thatbrings us back to local courts, which aren’t transplantable, and local rules,which are only moderately transplantable. Hence the country ranking of 1.An individual company gets a slightly higher 2 ranking because the companycan create some foreign liability for itself by listing its shares on a foreignexchange, and the company’s liability indirectly affects the directors.

Market Transparency

(19) Transparency of trading prices (company ranking = 4, countryranking = 3).

A company can ensure transparency of trading prices by listing on aforeign exchange in a country with strong transparency rules and hiring agood registrar, which can refuse to register share transfers that don’t comply

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with the transparency rules. But many countries restrict foreign ownershipof shares, restrict listing on a foreign exchange, or insist that major com-panies also list on a domestic exchange with weaker transparency. Hencethe company ranking of 4.

A country can potentially adopt transparency rules, a unified registrar,and rules about when the registrar should record share transfers. Yet, in myexperience, efforts to achieve these goals often meet various technical diffi-culties. Also, company insiders and local investment bankers, who benefitfrom nontransparency, often oppose the rules and impede the process ofimplementing them. Moreover, a country needs to be able to enforce thetransparency rules against the exchange and the registrars. On balance, acountry ranking of 3 seems warranted.

(20) An enforced ban on market manipulation (company ranking = 3,country ranking = 2).

An effectively enforced ban on manipulating market prices is animportant accompaniment to market transparency rules. Making such aban effective requires local enforcement, because whether trading is benignor manipulative depends heavily on local facts—on who is doing the trad-ing, and for what purpose. The country ranking of 2 combines the feasibil-ity of adopting such a ban with the difficulty of enforcing it.

An individual company’s efforts to stop manipulation can be aided bythe company’s internal culture of compliance and by maintaining a goodrecord of trades. That warrants a higher company ranking of 3.

Self-Dealing Rules

(21) Procedural controls on self-dealing transactions (review by independ-ent directors, noninterested shareholders, or both) (company ranking = 4, coun-try ranking = 3).

A country can adopt procedural rules that require self-dealing transac-tions to be approved by noninterested directors or shareholders. But if theoverall disclosure environment is weak, managers may hide transactions orappoint compliant independent directors to approve them. If the court sys-tem is weak, shareholder lawsuits may fail even if the procedures aren’tfollowed. The country ranking of 3 combines the feasibility of importingthese rules with the difficulty of enforcing them.

A single company’s managers can follow the company’s own proce-dures. The company can engage good independent directors. Still, theextent to which insiders will take these steps depends on managerial cultureand on the risk that insiders will be caught if they cheat. Hence the com-pany ranking of 4.


(22) Accountant review of the disclosure of self-dealing transactions (com-pany ranking = 4, country ranking = 2).

A country can establish procedural devices such as accountant review oftransaction disclosure to control self-dealing. But the procedures can still catchonly a fraction of the self-dealing that insiders engage in, especially if thelocal accounting profession is weak. And the incentive to self-deal will bestrong as long as local enforcement is weak. Hence the country ranking of 2.

A single company can do better than a country, but is still limited by thesophistication of its accountants and general cultural acceptance of self-dealing.

(23) Enforced securities or other rules banning insider trading (companyranking = 3, country ranking = 2).

Insider trading can be banned as a formal matter, but policing insidertrading is difficult everywhere, and nearly impossible if local institutions areweak. Much of the proof (A is related to B, who knows C, who actuallytraded) will be local, and thus hard to come by. It helps a bit if a particularcompany is listed on a foreign exchange with an active surveillance opera-tion. But the foreign exchange will usually hit a dead end when it investi-gates home-country-based trading. These enforcement problems producea company ranking of 3 and a country ranking of 2.

Other Institutions

(24) An active financial press and securities analysis profession (companyranking = 3, country ranking = 2).

The financial press must be mostly homegrown. It can’t be tailored toa particular company’s needs. Critical coverage can be chilled by overly broadlocal libel rules or, in some countries, cruder threats and sometimes actionsagainst offending journalists. At the same time, a country can improve finan-cial reporting by welcoming the international financial press (the Wall StreetJournal, Financial Times, Economist, and the like). These journals can providesome reporting themselves, and their example can also raise local profes-sional standards. A country can also encourage foreign investment banks toestablish local offices; the banks will then hire local analysts.

Large companies can encourage coverage by the press and securitiesanalysts, hence the higher ranking (3 instead of 2) for a company than for anentire country.

(25) A good accounting rule-writing organization (company ranking = 5,country ranking = 4).

Building a domestic rule-writing organization is hard, but companies andcountries that adopt a foreign set of accounting standards can largely piggybackon the organization that writes these rules and keeps them updated. That

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warrants a company ranking of 5. The possible need for specialized local rules,and for integrating the rules with other domestic laws, explains the lowercountry ranking.

B. Can Substitute Institutions Facilitate Piggybacking?

Some readers of this Article have commented that they can imaginenew institutions that could partially substitute for weak local regulation. Forexample, a company can bond its promise to obey another country’s high-quality rules by amending its charter, or by depositing assets in an interest-bearing escrow account in that country that will be available to satisfy a courtjudgment. Purchasing a directors’ and officers’ insurance policy can have asimilar effect.

Creative efforts to limit domestic risk can be important. For example,companies in countries with significant political risk sometimes go to greatlengths to issue securitized debt that reduces this risk.56 This suggests thatsimilar efforts could reduce the share price discounts that result from weaklocal regulation.

And yet, such substitutes mostly haven’t developed. One possibleexplanation is that no one has seriously tried. The substitutes are a finan-cial innovation yet to be born. A competing explanation is that the gainsfrom innovation are smaller than the associated transaction costs. The firstmover in adopting a new institution bears much higher transaction coststhan later adopters. The first mover will also suffer from informationasymmetry because investors won’t understand the innovation and will beskeptical about whether it will work as promised. We can’t easily distin-guish between these two explanations. But I suspect that if the gains werelarge and capturable at modest cost, we’d see some efforts to capture them.

Consider the escrow account strategy. First, the escrow amount mustbe only a fraction of the capital the company plans to raise, or else thecompany won’t raise any net investable capital. But a fractional escrow isonly fractionally effective in discouraging self-dealing. Second, an escrowwill increase capital-raising costs. For example, if flotation costs are 10 per-cent of the gross amount raised, and one-third of the net proceeds areplaced in escrow, the company faces flotation costs of 17 percent of theinvestable amount raised.57 Third, tax rules may raise the cost of placingfunds in an escrow account. Fourth, language barriers and weak home-

56. See Claire A. Hill, Latin American Securitization: The Case of the Disappearing Political

Risk, 38 VA. J. INT’L L. 293 (1998).57. In this example, for each $100 gross amount raised, the net amount raised is $90, of

which $60 is investable. Flotation costs are $10, which is one-sixth (17 percent) of $60.


country institutions may make it hard for investors to prove self-dealing andthereby collect on the escrow. Finally, the escrow strategy requires complexcontracting over the conditions to be satisfied before the escrow can bereleased.

Consider next the charter amendment strategy: Companies can limitself-dealing transactions in their charters. Insiders of already public compa-nies won’t often propose these limits, which would reduce the insiders’ability to extract value from the company. Insiders of companies goingpublic for the first time have incentives to adopt these limits to get a bettersale price for their shares, but still face multiple problems, including: (1)investors won’t know how much weight to place on a new, untested provi-sion; (2) such a provision may signal to investors that the firm faces highself-dealing risk, thus undercutting the provision’s value; (3) the malleabil-ity of corporate form may let the insiders escape coverage, if they laterdecide to; and (4) investor attention will be diverted from understandingthe prospects of the business to understanding the fine details of a charterprovision.

IV. EMPIRICAL EVIDENCE

Stock markets provide a way for growing companies to raise capital,but they are not the only such way. Bank financing and internal financing,including the internal capital market of a conglomerate firm, offeralternatives. If these alternatives work well, whether a country has a strongsecurities market won’t greatly affect its economic prospects. This partassesses what we know about whether (and how much) a country shouldcare about developing a strong securities market.

At a qualitative level, there is reason to believe that securities marketshave some advantages over their principal competitors as a means to raisecapital (Part A). In addition, a recent body of empirical evidence supportsthe core argument of this Article by linking the strength of investor protec-tion to the strength of a country’s securities markets (Part B), and linkinginvestor protection and the strength of securities markets to economicgrowth (Part C).

The economic importance of strong securities markets should notbe overstated. Some advanced economies have these markets; others havedeveloped decent functional substitutes.58 At the same time, many of the

58. For discussion of the ways in which different capital market systems can achieve similarresults (functional convergence), see Ronald J. Gilson, Globalizing Corporate Governance: Conver-gence of Form or Function, 49 AM. J. COMP. L. (forthcoming 2001), available at http://papers.ssrn.com/paper.taf?abstract_id=229517 (Social Science Research Network).

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institutions that support strong securities markets are needed if a country isto have strong capital markets of any sort.

A. The Qualitative Case for Strong Securities Markets

Securities markets have a number of potential advantages over bankfinancing and internal financing as a means to finance firm growth. First,countries with strong securities markets can rely more on equity and long-term debt financing, and less on bank loans and short-term debt. Banks areprone to credit crunches and other troubles that can reverberate throughthe whole economy. Even in advanced bank-centered countries, usually withdecent regulators, bad bank loans can have macroeconomic repercussions—witness Japan in the 1990s. Less-developed countries, often with weak regu-lators, are even more likely to face bank-driven financial collapses andresulting bailouts and recessions. Banks are also a cash business, hence easyto loot, especially in countries with weak investor protections. And short-term financing can increase the severity of economic crises, as investors refuseto re-lend when the need for capital is greatest.59

Second, when external equity markets are weak, family-controlledconglomerates create internal capital markets instead. Especially in eco-nomic downturns, these conglomerates often send good money after bad inan effort to prop up money-losing subsidiaries. And many conglomeratesthat do well when run by a first-generation entrepreneur run into troubleonce the heirs take control.60

It’s striking, and likely not coincidental, that the East Asian countriesthat best survived the 1997–1998 Asian financial crisis either had relativelystrong stock markets (Taiwan, Hong Kong, and Singapore) or a mostly closedeconomy (China, most notably). As Simon Johnson and coauthors report,“Measures of corporate governance, particularly the effectiveness of protec-tion for minority shareholders, explain the extent of [currency] depreciation

59. On the disadvantages of short-term financing (advantages of long-term bond

financing), see NILS H. HAKANSSON, THE ROLE OF A CORPORATE BOND MARKET IN ANECONOMY—AND IN AVOIDING CRISES (working paper, 1999), available at http://papers.ssrn.com/paper.taf?abstract_id=171405 (Social Science Research Network); Raghuram G. Rajan & LuigiZingales, Which Capitalism? Lessons from the East Asian Crisis, J. APPLIED CORP. FIN., Fall 1998,at 40.

60. On the role of conglomerates in offering internal capital markets in emerging economies,see, for example, Tarun Khanna & Krishna Palepu, Is Group Affiliation Profitable in Emerging Mar-kets? An Analysis of Diversified Indian Business Groups, 55 J. FIN. 867 (2000). On the mixed recordof second-generation family members in running family firms, see Randall K. Morck, David A.Stangeland & Bernard Yeung, Inherited Wealth, Corporate Control and Economic Growth: TheCanadian Disease?, in CONCENTRATED CORPORATE OWNERSHIP 319 (Randall K. Morck ed.,2000).


and stock market decline [in the crisis] better than do standard macro-economic measures.”61

Their explanation for this result stresses a vicious cycle that can arisein a country with weak legal protections against self-dealing. Controllingshareholders’ incentives to self-deal are tempered in good economic timesby concern for reputation. When the economy turns sharply down, manyfirms face possible insolvency. Their owners are now in a final period, inwhich reputational constraints are weak, and scramble for the exits. Insiderlooting exacerbates stock market decline; the stock market decline reducesfirms’ prospects and encourages looting, and the looting exacerbates theeconomic downturn.

Third, a stock market lets companies rely more on external capital andless on internal capital. This helps firms grow rapidly and gives companiesthat focus on a single core business an advantage over diffuse conglomer-ates. In the United States, conglomerates are usually less efficient thanmore focused firms.62 Conglomerates remain strong in countries with weakstock markets, partly because the conglomerate form can provide the capitalthat a rapidly growing business needs.

Fourth, a strong equity market permits venture capital and leveragedbuyout promoters to exit from their investments through an initial publicoffering. The availability of this public market exit may be an importantprecursor to a vibrant venture capital industry.63

Fifth, foreign capital inflows can support domestic growth. Securitiesmarkets allow the inflow channel of portfolio investment, and thus canincrease total capital inflows.

Finally, the same institutions that strengthen stock markets also oftenstrengthen the banking system. Honest courts and prosecutors and a strongaccounting profession are needed whatever the nature of a country’s capitalmarket. So too for the government capacity to regulate core capital marketplayers, whether they be commercial banks or investment banks. And thelower cost of capital provided by a strong stock market will benefit bankswhen they raise their own equity capital, permitting the banks to lend morecheaply. In many countries, banks are among the leading publicly tradedcompanies, and are thus important beneficiaries of strong stock markets.

61. Simon Johnson, Peter Boone, Alasdair Breach & Eric Friedman, Corporate Governance

in the Asian Financial Crisis, 58 J. FIN. ECON. 141 (2000) (abstract).62. For a review of evidence on the efficiency of conglomerate firms, see RONALD J.

GILSON & BERNARD S. BLACK, THE LAW AND FINANCE OF CORPORATE ACQUISITIONS ch. 9(2d ed. 1995).

63. See Black & Gilson (1998), supra note 27.

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Looking narrowly at developed countries, stock markets and banks canlook like substitute sources of capital. But across a broad range of countriesin different stages of development, strong banking systems are usually foundtogether with strong stock markets. For example, Ross Levine and SaraZervos report a strong 0.65 correlation between bank loans to private sectorborrowers and stock market capitalization, both measured as a percentage ofGDP.64

B. Empirical Evidence: Investor Protection and Strong Capital Markets

Research on the empirical correlation between investor protection andthe strength of a country’s securities markets or its economy is in its infancy.Early results suggest that both correlations exist; further research is neededto tease out the relationship between them. Issues of multicollinearity andunclear causation abound. A threshold issue is the proxy that one uses forsecurities market strength. The most common proxies are stock market capi-talization as a percentage of GDP and liquidity (average bid-asked spread asa percentage of share price).

In a series of papers, Rafael La Porta, Florencio Lopez-de-Silanes,Andrei Shleifer, and Robert Vishny (LLSV) develop evidence that coun-tries with stronger legal protection of minority shareholders have largerstock market capitalization as a percentage of GDP, higher valuation ofminority shares (measured by Tobin’s q), less concentrated share ownership,more public companies relative to population, and higher dividend payoutrates.65

The premium price accorded to high-voting shares, for companies thathave two classes of tradable shares, offers a rough measure of the level ofprivate benefits that outside investors expect insiders (who mostly holdhigh-voting shares) to extract. Franco Modigliani and Enrico Perottidocument an inverse relationship between the premium on high-voteshares and stock market capitalization as a percentage of GDP, and also an

64. See Ross Levine & Sara Zervos, Stock Markets, Banks, and Economic Growth, 88 AM.

ECON. REV. 537, 543 (1998).65. See Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer & Robert Vishny, Legal

Determinants of External Finance, 52 J. FIN. 1131 (1997); Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer & Robert Vishny, Law and Finance, 106 J. POL. ECON. 1113 (1998);Rafael La Porta, Florencio Lopez-de-Silanes & Andrei Shleifer, Corporate Ownership Around theWorld, 54 J. FIN. 471 (1999); FLORENCIO LOPEZ-DE-SILANES, ANDREI SHLEIFER & ROBERTVISHNY, INVESTOR PROTECTION AND CORPORATE VALUATION (Nat’l Bureau of Econ.Research, Working Paper No. W7403, 1999), available at http://papers.ssrn.com/paper.taf?abstract_id=227583 (Social Science Research Network); Florencio Lopez-de-Silanes, AndreiShleifer & Robert Vishny, Agency Problems and Dividend Policies Around the World, 55 J. FIN. 1(2000).


inverse correlation between measures of corruption and stock market capi-talization.66 And Tatiana Nenova finds a strong inverse correlation betweenthe premium on high-vote shares and legal protection for minority investors.67

Ross Levine confirms the LLSV correlation between investor rights andstock market capitalization for a different sample of countries, and finds aseparate correlation between the quality of accounting disclosure and stockmarket capitalization. The latter correlation supports the view, expressedabove, that strong accounting rules are a core market-supporting institution.68

The evidence on the correlation between legal protection and thestrength of banks is consistent with the evidence on securities markets. Forexample, Ross Levine finds that measures of creditor rights and of generalcontract enforcement predict a larger banking sector and greater develop-ment of financial intermediaries generally.69

C. Empirical Evidence: Investor Protection, Capital Markets,and Economic Growth

Strong capital markets, fostered by strong investor protections, oughtto reduce a firm’s cost of capital and thereby encourage investment. Invest-ment, in turn, ought to pay off in faster growth. However, given the manyfactors that affect investor protection, on the one hand, and investmentand growth, on the other, teasing this predicted relationship out of the datawill be hard, even if the relationship in fact exists. The most that can besaid at this point is that the correlations between strong investor protectionand faster growth, and between strong capital markets and growth, are con-sistent with the available data.

At a general level, Daniel Kaufmann, Aart Kraay, and Pablo Zoido-Lobaton report that broad measures of effective government and of “ruleof law” (predictability of court decisions and enforceability of contracts)correlate positively with per capita GDP, while corruption correlates

66. See Franco Modigliani & Enrico Perotti, Security Versus Bank Finance: The Importance

of a Proper Enforcement of Legal Rules, 1 INT’L REV. FIN. 81 (2000).67. See TATIANA NENOVA, THE VALUE OF CORPORATE VOTES AND CONTROL BENEFITS:

A CROSS-COUNTRY ANALYSIS (working paper, 2000), available at http://papers.ssrn.com/paper.taf?abstract_id=237809 (Social Science Research Network).

68. See Ross Levine, Napoleon, Bourses, and Growth: With a Focus on Latin America, inMARKET AUGMENTING GOVERNMENT (Omar Azfar & Charles Cadwell eds., forthcoming 2001).

69. See Ross Levine, Law, Finance, and Economic Growth, 8 J. FIN. INTERMEDIATION8 (1999); Ross Levine, The Legal Environment, Banks, and Long-Run Economic Growth, 30 J.MONEY, CREDIT & BANKING 596 (1998); see also Asli Demirguc-Kunt & Vojislav Maksimovic,Institutions, Financial Markets, and Firm Debt Maturity, 54 J. FIN. ECON. 295, 321 (1999) (findinga correlation between a measure of creditor rights and bank assets as a percentage of gross domes-tic product).

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inversely with GDP. In an endogenous variables (two-stage least squares)analysis, the direction of causation appears to run from better governance tohigher per capita GDP.70 Robert Hall and Charles Jones report similar resultsfor a single broad measure of social infrastructure.71 These broad governancemeasures are likely to correlate with investor protection along the dimen-sions suggested in this Article. But these studies do not address whether secu-rities markets are an important means through which countries with stronginstitutions achieve stronger growth.

Peter Henry finds a related correlation: Countries that open theirstock markets to foreign portfolio investment experience higher stock pricesand a resulting increase in physical investment. Henry attributes the higherstock prices to greater diversification by foreign investors, which makesthem willing to accept lower expected returns than domestic investors. Asecond possible reason is that the same forces that lead to liberalization cor-relate with stronger investor protections.72

Levine and Zervos report that stock market strength (measured byliquidity) and commercial bank strength (measured by loans to private bor-rowers as a percentage of GDP) separately predict economic growth. Thissuggests that strong stock markets and strong commercial banks are separateprecursors of growth—more complements than substitutes. Stock marketsize (relative to GDP) also predicts economic growth, but less robustly thanliquidity. The observed correlations survive when the authors add a controlvariable for legal efficiency. This suggests that capital market developmenthas a positive impact on growth, apart from its institutional precursors.73

Jeffrey Wurgler reports one reason why stock market strength may predictfaster growth: A strong stock market predicts better capital allocation. He

70. See DANIEL KAUFMAN, AART KRAAY & PABLO ZOIDO-LOBATON, GOVERNANCE

MATTERS (World Bank, Policy Research Working Paper No. 2196, 1999).71. See Robert E. Hall & Charles I. Jones, Why Do Some Countries Produce So Much More

Output per Worker than Others?, 114 Q.J. ECON. 83 (1999).72. See Peter Henry, Do Stock Market Liberalizations Cause Investment Booms?, 58 J. FIN.

ECON. 301 (2000); Peter Henry, Stock Market Liberalization, Economic Reform, and Emerging Mar-ket Equity Prices, 55 J. FIN. 529 (2000).

73. See Raymond Atje & Boyan Jovanovic, Stock Markets and Development, 37 EUR. ECON.REV. 632 (1993) (also finding a correlation between stock market liquidity and economicgrowth); Levine & Zervos (1998), supra note 64; P.L. Rousseau & P. Wachtel, Equity Markets andGrowth: Cross-Country Evidence on Timing and Outcomes, 1980–1995, 24 J. BANKING & FIN. 1933(2000). But see Richard D.F. Harris, Stock Markets and Development: A Re-Assessment, 41 EUR.ECON. REV. 139 (1997) (finding no significant correlation between stock market liquidity andcurrent growth or investment). For theoretical models linking stock market liquidity to lower costof capital and therefore faster growth, see Valerie R. Bencivenga, Bruce D. Smith & Ross M.Starr, Transactions Costs, Technological Choice and Economic Growth, 67 J. ECON. THEORY 53(1995), and Ross Levine, Stock Markets, Growth, and Tax Policy, 46 J. FIN. 1445 (1991).


also finds that strong protection of minority investors directly predictsimproved capital allocation.74

A separate line of research finds a correlation between banking sectorstrength and economic growth.75 This raises the possibility that banks are thereal growth engine, and strong stock markets merely happen to be cor-related with strong banks. The Levine and Zervos results suggest that banksand stock markets have separate growth-promoting effects.

Raghuram Rajan and Luigi Zingales argue that greater financial sectoractivity might merely anticipate, rather than cause, future economicgrowth. They respond to this concern by reporting evidence that a com-bined measure of banking sector and stock market size predicts faster growthdifferentially in industries that rely on external financing.76 Ross Levineand coauthors develop evidence of a causal connection running from inves-tor protection to strong capital markets to future growth. They find that(1) legal protection of creditors and general contract enforcement predictsstronger banks, and the portion of banking development attributable tostronger creditor protection predicts future economic growth; and (2) legalprotection of shareholder rights and strong accounting rules predict strongstock markets, and the portion of stock market development attributable toshareholder rights and accounting disclosure predicts future economic growth.77

Asli Demirguc-Kunt and Vojislav Maksimovic study firm-level ratherthan economywide growth. They report that firms in countries with strongerlegal systems and more active stock markets, measured by annual turnoverratio, rely more on long-term external financing (both equity and long-termdebt) to finance growth, and earn lower returns on invested capital. This isconsistent with a lower cost of capital and with greater competition, fos-tered by greater access to capital. Like Levine and Zervos, they find strongerresults for a measure of stock market liquidity than for stock market size (asa percentage of GDP). A variable for an effective legal system predictsfaster firm growth and greater reliance on equity financing but is insignifi-cant for long-term debt. In a regression with variables for legal effective-ness, long-term debt, and equity, the long-term debt and equity variables

74. See Jeffrey Wurgler, Financial Markets and the Allocation of Capital, 58 J. FIN. ECON. 187

(2000).75. See Thorsten Beck, Ross Levine & Norman Loayza, Finance and the Sources of Growth,

58 J. FIN. ECON. 261 (2000); Ross Levine, Financial Development and Economic Growth: Views andAgenda, 35 J. ECON. LITERATURE 688 (1997) (literature survey).

76. See Raghuram G. Rajan & Luigi Zingales, Financial Dependence and Growth, 88 AM.ECON. REV. 559 (1988).

77. See Levine (1999), supra note 69.; Levine (2001), supra note 68; Ross Levine, NormanLoayza & Thorsten Beck, Financial Intermediation and Growth: Causality and Causes, 46 J. MONE-TARY ECON. 31 (2000).

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are significant and the legal effectiveness variable is not, suggesting that thevalue of an effective legal system in promoting firm growth is largely cap-tured by its effect on the financing variables.78

Finally, while this Article has focused on the prerequisites for stockmarkets, rather than public debt markets, another paper by Demirguc-Kuntand Maksimovic links the two—an active stock market (measured by turn-over ratio) predicts greater firm reliance on long-term debt.79

V. STRONG AND WEAK SECURITIES MARKETS: ASEPARATING EQUILIBRIUM?

The interdependence of many of the institutions that control informa-tion asymmetry and self-dealing creates the potential for two separatingequilibria to exist. In the first, lemons equilibrium, many institutions thatsupport a strong securities market are weak or absent. Honest companies(except a few large companies that develop their own reputations) rarelyissue 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.80 If self-dealing is easy, dispersed owner-ship is unstable, because a raider can capture a high percentage of a com-pany’s value by buying only 51 percent of its shares.81

In the second, strong markets equilibrium, strong investor protectionproduces prices that induce honest companies to issue shares, which increasesthe average quality of the shares that are issued, which further increasesshare prices and encourages more honest issuers to issue shares. But, highershare prices also increase the incentive for dishonest issuers to sell shares.Thus, the stability of the strong markets equilibrium depends on the contin-ued strength of the institutions that control information asymmetry andself-dealing.

Moreover, many institutions that support a strong securities market areendogenous to the existence of that market. For example, frequent public

78. See Asli Demirguc-Kunt & Vojislav Maksimovic, Law, Finance, and Firm Growth, 53 J.

FIN. 2107 (1998).79. See Demirguc-Kunt & Maksimovic (1999), supra note 69, at 321–27.80. For an early model of companies’ incentives not to issue equity if insiders have more

information than investors, see Stewart C. Myers & Nicholas S. Maijluf, Corporate Financing andInvestment Decisions When Firms Have Information that Investors Do Not Have, 13 J. FIN. ECON. 187(1984).

81. See LUCIAN ARYE BEBCHUK, A RENT-PROTECTION THEORY OF CORPORATE OWNER-SHIP AND CONTROL (Nat’l Bureau of Econ. Research, Working Paper No. W7203, 1999), availableat http://papers.ssrn.com/paper.taf?abstract_id=203110 (Social Science Research Network).


offerings of securities encourage investment bankers to invest in the reputa-tion needed to support these offerings, encourage a stock exchange to developstrong listing standards, and encourage market participants to support a sophis-ticated securities regulatory agency, good accounting rules, and a sophis-ticated accounting-rule-writing body. Investor demand for securities producesdemand for a security analysis profession. The investment fund industry islarge and politically influential because it has a large, deep securities marketthat the funds can invest in. And so on.

Political support for strong securities regulation can also involve a sepa-rating equilibrium. If securities markets are weak, companies and countrieswill develop other ways to finance businesses. Bank financing is an obviousalternative. But bank-dominated financing produces strong banks, bothfinancially and politically. The banks will resist legal changes that mightstrengthen securities markets. Family-run conglomerates are a second alter-native. Once built, they reduce the need for a strong securities market.Insiders of family conglomerates and other already public companies will thenfight against rules and institutions that limit self-dealing.

Conversely, a country with a strong securities market is more likely tostrengthen and enforce the rules that maintain that market. In the UnitedStates, the Securities and Exchange Commission is a strong regulator partlybecause the securities and investment fund industries want it to be. Self-dealing controls are strong partly because investors and reputational inter-mediaries support strong controls and provide a counterweight to pressurefrom public company managers for weaker rules. The Financial AccountingStandards Board writes relatively strong accounting rules partly becauseinstitutional investor pressure for additional disclosure offers a counter-weight to pressure from companies for less detailed disclosure.

The prediction that political forces will reinforce a separating equilib-rium is consistent with research that links the strength of particular institu-tions with a country’s capital market structure. Ray Ball and coauthorsreport that common law countries have a better match between accountingand economic income than civil law countries.82 And Laura Beny finds thatcountries with weak insider trading rules have more concentrated ownership,

82. See RAY BALL, S.P. KOTHARI & ASHOK ROBIN, THE EFFECT OF INTERNATIONAL

INSTITUTIONAL FACTORS ON PROPERTIES OF ACCOUNTING EARNINGS (working paper, 1999),available at http://papers.ssrn.com/paper.taf?abstract_id=176989 (Social Science Research Net-work); see also RAY BALL, ASHOK ROBIN & JOANNA SHUANG WU, INCENTIVES VERSUSSTANDARDS: PROPERTIES OF ACCOUNTING INCOME IN FOUR EAST ASIAN COUNTRIES, ANDIMPLICATIONS FOR ACCEPTANCE OF IAS (working paper, 2000), available at http://papers.ssrn.com/paper.taf?abstract_id=216429 (Social Science Research Network).

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and less liquid securities markets, than countries with more dispersed shareownership.83

A country with a strong securities market is more likely to build aventure capital industry, which depends in important part on the possibilityof exit from portfolio investments through an initial public offering.84 Theventure capital industry then generates a regular supply of initial publicofferings, which strengthen demand for the other institutions that supportthese public offerings.

The cultural preconditions for strong or weak securities markets canalso be self-reinforcing. In a strong market, good disclosure and limited self-dealing become self-reinforcing norms because they are how most business-people behave, regulators can aggressively pursue the few departures fromthe norm, and there is political support for the funding to maintain theenforcement that reinforces the cultural norm. In a weak market, weakdisclosure and extensive self-dealing become self-reinforcing norms. Manybusinesspeople behave this way, many of them get away with self-dealingbecause regulators (even if honest and decently funded) can address onlythe most egregious cases, and the self-dealers oppose stronger rules or better-funded regulators.

Corruption, a critical obstacle to strong securities markets, is also likelyto be endogenous. In weak markets, honest, decently funded judges, regula-tors, and prosecutors are less likely to emerge, because they threaten thepolitically powerful controllers of large enterprises. The wealth of enter-prise controllers in turn provides the capital needed to sustain the statusquo of corruption and weak enforcement. Also, once corruption becomesentrenched, dishonest people will (and honest people won’t) seek to workas regulators. And no one resists anticorruption reforms more strongly thanalready corrupt regulators and judges, who face both a threat to their liveli-hood and the risk of disgrace and criminal prosecution for past acts.

There is an important interrelationship between government corrup-tion, the rules that judges and regulators are supposed to enforce, and theresources they are given to do so. A corrupt government isn’t likely to writestrong rules against self-dealing or fund strong enforcement efforts. Com-panies will offer inducements to legislators to include loopholes in the rulesand to limit enforcement funding; legislators may also understand the advan-tages to them of slush funds derived from self-dealt assets.

83. See LAURA BENY, A COMPARATIVE EMPIRICAL INVESTIGATION OF AGENCY AND

MARKET THEORIES OF INSIDER TRADING (Harvard Law Sch., John M. Olin Ctr. for Law,Econ. & Bus., Discussion Paper No. 264, 1999), available at http://papers.ssrn.com/paper.taf?abstract_id=193070 (Social Science Research Network).

84. See Black & Gilson (1998), supra note 27.


Thus, for economic, political, and cultural reasons, there is the poten-tial for two separate equilibria to arise—a strong markets equilibrium, inwhich the core endogenous institutions have been built and enjoy politicalsupport, and a lemons equilibrium in which many of these institutions areabsent and building them faces strong political opposition.85

I intend the concept of a separating equilibrium to be a qualitativeone. Incremental improvements in a country’s securities market are possi-ble. Even in the weak markets equilibrium, some companies can developstrong reputations and obtain respectable prices when they sell shares tooutside investors. The better a country’s institutions, the more companieswill be able to sell shares, relying partly on their own and partly on thecountry’s reputation. Moreover, incremental improvements can put a coun-try on the road to the strong markets equilibrium, because each step rein-forces the previous ones, and makes future steps easier, both logistically andpolitically.

Nonetheless, the concept of separating equilibria can capture the diffi-culty a country is likely to face in moving from a bank-centered capitalmarket, in which mature companies go public largely based on their ownreputations, to a stock-market-centered capital market in which new com-panies have access to public capital because they can trade on the built-upreputations of others, especially reputational intermediaries, and on factorslike culture and enforcement that make fraud or self-dealing less likelyamong companies that haven’t yet built their own reputations. Parts I andII of this Article can be seen as an attempt to develop minimum conditionsfor a country to achieve the strong markets equilibrium.

VI. IMPLICATIONS

A. Different Types of Monitoring: Investor Protectionand Firm Performance

A major theme in comparative research on corporate governance overthe past decade has been to assess the comparative strengths and weaknesses

85. ROE (1999), supra note 5, offers an analysis that, like mine, stresses the endogeneity of

securities markets, but with a very different analysis of the interaction between politics and acountry’s capital markets. He argues that Western European social democracies are politicallyhostile to the emphasis on shareholder profits that characterizes countries with strong securitiesmarkets, and develop rules that discourage these markets and encourage less transparent bank-centered capital markets, which make it easier for government to pressure managers to transferwealth to other stakeholders. His analysis is limited to rich countries, which wouldn’t be richunless they have solved tolerably well some of the most severe problems that prevent the devel-opment of either strong securities markets or a strong banking sector.

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of bank-centered and stock-market-centered capital markets. The standarddebate posits that bank-centered capital markets, such as Germany andJapan, offer greater ability of banks to monitor managers and ensure thatthe company is well managed. That company insiders won’t simply colludewith the bankers to steal from the company through self-dealingtransactions is taken for granted or treated as a minor concern.86

The standard analysis recognizes that stock-market-centered capitalmarkets also have potential advantages. For one thing, banks may discour-age risk taking, in order to protect their mostly fixed claims. Stock-market-centered systems can also provide greater liquidity to investors, and greatercapital-raising opportunities for companies with intangible assets, againstwhich banks can’t easily lend. They can develop an active market forcorporate control, that can indirectly monitor performance and partly sub-stitute for weaker direct shareholder oversight. Still the debate assumesthat bank-centered capital markets can produce stronger monitoring thanstock-market-centered systems. The analysis developed above suggests thatthis assumption may be misplaced.

Monitoring has two basic dimensions—monitoring insiders, to ensurethat they don’t steal the company’s value from investors (shareholders orcreditors), and monitoring management performance, to ensure that a com-pany maximizes that value. I argue above that a country can develop strongsecurities markets only if it succeeds along the first dimension. This sug-gests that countries with stock-market-centered systems are likely to havestronger protections against self-dealing than countries with bank-centeredsystems. Bank-centered systems may even develop partly because a countrycontrols self-dealing too poorly to permit a stock-market-centered capitalmarket to flourish.87

It’s also unclear which type of capital market is better at monitoringmanagers to ensure that they maximize firm value. This form of monitoringrequires information about manager performance, skill to interpret thatinformation, and power to act if performance is weak. Stock-market-centered capital markets can provide better information about performancethan bank-centered capital markets. Also, equity investors may havestronger assessment skills than bank loan officers. They may be smarter on

86. For pieces of this debate, see MARK J. ROE, STRONG MANAGERS, WEAK OWNERS:THE POLITICAL ROOTS OF AMERICAN CORPORATE FINANCE (1994); John C. Coffee, Jr.,Liquidity Versus Control: The Institutional Investor as Corporate Monitor, 91 COLUM. L. REV. 1277(1991); and Ronald J. Gilson, Corporate Governance and Economic Efficiency: When Do InstitutionsMatter?, 74 WASH. U. L.Q. 327 (1996).

87. For a related suggestion that large shareholders emerge when other means of controllingshareholder-manager agency costs (of which self-dealing is one component) are weak, see ROE(1999), supra note 5.


average (they are certainly better paid), and won’t have the risk aversionthat is embedded in bank lending practices.

Even if dispersed shareholders as monitors have information, they havelimited power or incentive to act on that information. But some constraintsstill exist. A low stock price, complaints from unhappy shareholders, andnegative reports from analysts or the financial press all send signals to theboard of directors about management’s performance, which some boardswill heed. A low stock price makes it harder for the company to raise capi-tal for new ventures, and makes it a more attractive takeover target. Thecombination of better disclosure, less risk-averse and perhaps more skilledmonitors, albeit with less direct ability to act on adverse disclosure, mayplausibly generate more, or not significantly less, discipline than bank over-sight provides in bank-centered capital markets. Put differently, the liquid-ity offered by stock-market-centered capital markets may not come at a costin weaker monitoring, once we define monitoring broadly to include bothcontrols against weak management (on which most corporate governancescholarship focuses) and controls against self-dealing (which loom large inmany countries).

B. Competition Between Securities Regulators

Should firms be able to choose their securities regulator? This wouldopen up regulatory competition, akin to American competition betweenstates for corporate charters. Partial competition exists already, throughfirms’ choices of where to list and issue their shares. But competition advo-cates would go further. Roberta Romano argues that letting American statescompete to offer securities regulation could produce more cost-effectivedisclosure rules; Stephen Choi and Andrew Guzman propose competitionamong national securities regulators.88 Merritt Fox responds by proposingnational regulation of home-country issuers, regardless of where they issuesecurities; Uri Geiger prefers disclosure rules established by an internationalsuperregulator.89

88. See Stephen J. Choi & Andrew T. Guzman, Portable Reciprocity: Rethinking the Interna-

tional Reach of Securities Regulation, 71 S. CAL. L. REV. 903 (1998); Roberta Romano, EmpoweringInvestors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359 (1998); Roberta Romano,The Need for Competition in International Securities Regulation: A Response to Critics, 3 THEO-RETICAL INQUIRIES L. (forthcoming 2001).

89. See Merritt B. Fox, Securities Disclosure in a Globalizing Market: Who Should RegulateWhom, 95 MICH. L. REV. 2498 (1997); Merritt B. Fox, The Political Economy of Statutory Reach:U.S. Disclosure Rules in a Globalizing Market for Securities, 97 MICH. L. REV. 696 (1998); MerrittB. Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment,85 VA. L. REV. 1335 (1999); Uri Geiger, The Case for the Harmonization of Securities DisclosureRules in the Global Market, 1997 COLUM. BUS. L. REV. 243 (1997); Uri Geiger, Harmonization of

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My analysis suggests that this debate is misguided. It focuses primarilyon disclosure rules, when the real competition is between national systemsfor fostering strong disclosure and controlling self-dealing. Disclosure rulesare a small part of the network of institutions that support strong disclosure;the securities regulator’s role in adopting disclosure rules is not criticalto having good rules; and this role is a small part of the regulator’s overalljob. The core regulatory role is enforcing standards of conduct againstissuers and reputational intermediaries who flagrantly violate the disclosurerules, not tweaking those rules at the margin.

Moreover, even on the narrow terrain of disclosure rules, competitionis unlikely to achieve the intended goal of producing more cost-effectiverules. Companies can already prepare disclosure to a higher foreign stan-dard if they like. Regulatory competition lets companies that face strictlocal standards choose more relaxed standards instead. Companies havetwo possible reasons for doing so—to hide something—or to save on com-pliance costs. To see which motive is likely to dominate, consider the incen-tives of a company that believes that the value to investors of more detailedaccounting disclosures exceeds the company’s cost to provide the informa-tion, and wants to switch to a more relaxed set of disclosure rules.

A U.S. company that adopts (say) German accounting, which permitshidden reserves, will suffer a double hit to its share price. It will lose thebenefit of comparability with similar U.S. companies, and investors willassume that it has something to hide. This is the same adverse selectioneffect I described earlier in this Article, in a different guise.

Investors know that, on average, companies that choose less stringentdisclosure want to hide something—perhaps bad results, management com-pensation, or self-dealing transactions. They will discount the company’sshare price for that risk, despite the company’s predictable claim that it justwants to reduce its accounting costs. This will make switching costly andlead many potential switchers that want to reduce accounting costs not toswitch. But companies with something to hide will still switch as long aswhat they plan to hide is as bad or worse than what investors will assume.

This adverse selection effect increases the likelihood that the compa-nies that switch have something to hide, and increases the discount thatinvestors will apply to the switchers. That further discourages companies

Securities Disclosure Rules in the Global Market—a Proposal, 66 FORDHAM L. REV. 1785 (1998); seealso Howell Jackson & Eric Pan, Regulatory Competition in International Securities Markets: Evidencefrom Europe in 1999, 3 THEORETICAL INQUIRIES L. (forthcoming 2001) (reporting that disclosure inEuropean offerings by major European issuers exceeds most European requirements andapproaches U.S. levels, implying little change in disclosure practices if regulatory competitionwere permitted).


from switching to reduce accounting costs, increases the percentage of loss-hiding switchers, and increases the expected amount of bad news they arehiding. The adverse selection effect on price is compounded because thefewer companies that switch, the greater the loss to the switchers from los-ing comparability with nonswitching companies.

My own judgment is that the comparability and adverse-selection costsof switching will swamp the modest accounting cost savings. If so, competi-tion among regulators to issue disclosure rules will permit some companiesto hide bad news and won’t produce much pressure on rule writers to pro-vide cost-effective rules. Moreover, the competing regulators know thatmanagers make the switching decision, not shareholders. They often do sowithout the constraining influence of the need to obtain shareholderapproval. Regulators will be tempted to compete by pandering to the man-agers’ preference for laxer disclosure of manager compensation and self-dealing. This is arguably what happens today in the United States. TheUnited States permits foreign companies to provide more limited disclosurethan domestic companies, principally on the dimension of self-dealing dis-closure. And many insiders are happy to disclose less.90

C. Convergence in Capital Markets and Corporate Governance

An active current debate concerns the extent of likely convergencebetween different corporate governance systems. The polar positions in thisdebate can be represented by (1) the argument by Henry Hansmann andReinier Kraakman that convergence at the level of formal legal rules isalready largely complete;91 and (2) the argument by Lucian Bebchuk andMark Roe that political forces and path dependence will limit the extentof convergence.92 Ron Gilson takes an important intermediate position,emphasizing that different formal rules can produce similar outcomes, whichhe calls “functional convergence.”93 But functional convergence is ill defined

90. See Licht (2001), supra note 46.91. See Henry Hansmann & Reinier Kraakman, The End of History in Corporate Law, in

ARE CORPORATE GOVERNANCE SYSTEMS CONVERGING? (Jeffrey Gordon & Mark J. Roe eds.,forthcoming 2001), available at http://papers.ssrn.com/paper.taf?abstract_id=204528 (Social ScienceResearch Network).

92. See Lucian Arye Bebchuk & Mark J. Roe, A Theory of Path Dependence in CorporateOwnership and Governance, 52 STAN. L. REV. 127 (1999); see also Douglas M. Branson, The VeryUncertain Prospect of “Global” Convergence in Corporate Governance, 34 CORNELL INT’L L.J. (forth-coming 2001), available at http://papers.ssrn.com/paper.taf?abstract_id=244742 (Social ScienceResearch Network).

93. Gilson (2001), supra note 58.

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with respect to the level of generality at which outcomes are expected toconverge.94

This Article argues that a fair amount of functional convergence mustunderlie strong securities markets. To create these markets, countries mustsolve a limited number of core problems, including the information asym-metry and self-dealing problems that I stress. My analysis also suggests thatmuch of whatever convergence takes place (a topic on which I express noopinion here), will be functional (at a rather high level of generality) ratherthan formal. Formal legal rules play an important but limited role in acountry’s overall corporate governance system.95 Enforcement institutionsare also critical. And enforcement institutions diverge widely, are hard tochange quickly, and are not susceptible to formal convergence in the waythat legal rules are.

Moreover, the institutions that support securities markets and thus, inimportant part, corporate governance systems, tend to coevolve and to rein-force each other. Weakness in one can be offset by strength in another.

Consider two examples—one a legal rule, the other an enforcementinstitution. Consider first a takeout bid requirement when control changeshands, which is useful for controlling self-dealing. One important elementof convergence is surely the rights of minority shareholders in control trans-actions. But now consider some of the possibilities among countries thatacceptably solve the self-dealing problem. A country can require a takeout

94. A reasonable sampling of other contributions to the convergence literature includes

THEODOR BAUMS, CORPORATE GOVERNANCE SYSTEMS IN EUROPE—DIFFERENCES ANDTENDENCIES OF CONVERGENCE (working paper, 1998), available at http://papers.ssrn.com/paper.taf?abstract_id=10550 (Social Science Research Network); William W. Bratton & Joseph A.McCahery, Comparative Corporate Governance and the Theory of the Firm: The Case Against GlobalCross Reference, 38 COLUM. J. TRANSNAT’L L. 213 (1999); David Charny, The Politics of Corpo-rate Convergence, in ARE CORPORATE GOVERNANCE SYSTEMS CONVERGING?, supra note 91;Coffee (1999), supra note 2; Jeffrey Gordon, Pathways to Corporate Convergence? Two Steps on theRoad to Shareholder Capitalism in Germany: Deutsche Telekom and DaimlerChrysler, 5 COLUM. J.EUR. L. 219 (1999), postpublication version (2000) available at http://papers.ssrn.com/paper.taf?abstract_id=208508 (Social Science Research Network); Gerard Hertig, Convergence of SubstantiveRules and Convergence of Enforcement: Correlation and Tradeoffs, in ARE CORPORATE GOVER-NANCE SYSTEMS CONVERGING?, supra note 91; Amir N. Licht, International Diversity in SecuritiesRegulation: Some Roadblocks on the Way to Convergence, 20 CARDOZO L. REV. 227 (1998); JEFFREYMACINTOSH, INTERNATIONAL SECURITIES REGULATION: OF COMPETITION, COOPERATION,CONVERGENCE AND CARTELIZATION (working paper, 1995), available at http://papers.ssrn.com/paper.taf?abstract_id=10162 (Social Science Research Network); Curtis J. Milhaupt, PropertyRights in Firms, 84 VA. L. REV. 1145 (1998); Curtis J. Milhaupt & Geoffrey P. Miller, Cooperation,Conflict, and Convergence in Japanese Finance: Evidence from the ‘Jusen’ Problem, 29 LAW & POL’YINT’L BUS. 1 (1997); and Heidi Mandanis Schooner & Michael Taylor, Convergence andCompetition: The Case of Bank Regulation in Britain and the United States, 20 MICH. J. INT’L L. 595(1999).

95. See COFFEE (2001), supra note 19


bid with or without permitting minority shareholders to waive this right bymajority vote, requiring equal prices for controlling and noncontrollingshares, or adjusting the price for general market movements or the timevalue of money. Or, as the United States has, it can have no takeout bidrule, but substitute a norm of buying all outstanding shares at the same priceduring a change of control, policed by strong independent directors whorefuse to accept any other proposal—even though they can lawfully do sounder Delaware case law.96 These possibilities converge functionally at thelevel of generality of protecting minority shareholders against self-dealingby a new controlling shareholder, but in different ways, with differentdegrees of protection.

But a country can sustain a strong securities market with no takeoutbid rule or practice, if it otherwise strongly protects minority shareholdersagainst self-dealing, so that the self-dealing risk from a control changeis small. This arguably describes American practice until about 1985.Countries with and without takeout bid rules will then have convergedfunctionally at a higher level of generality—on whether their institutions,as a whole, protect minority investors against self-dealing.

Consider next an enforcement institution that some scholars, myselfamong them, consider useful in controlling self-dealing—a common lawlegal system. We can hope that this institution is not critically importantfor this task. Otherwise, most of the world can’t build strong securities mar-kets, because this institution isn’t transplantable. If strong markets emergein civil law countries, as recent signs suggest is happening, these countrieswill converge functionally with common law countries at the level of gen-erality of an overall set of institutions that protects minority investorsagainst self-dealing. But they will not converge—functionally or formally—in many important details of that system.

CONCLUSION: WHAT STEPS TO TAKE FIRST

The complex institutions that support strong securities markets can’tbe built quickly. As Lou Lowenstein explains for U.S. accounting practices,“our disclosure apparatus in all its parts—the accounting rules, the legalprofession, the administrative oversight, the legion of analysts, the press—has been built brick by brick over a long period.”97

96. See GILSON & BLACK (1995), supra note 62.97. Lowenstein (1996), supra note 17, at 1361–62.

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Some institutions can precede market development. Others will growonly as the securities market grows. Many transition economies have few ornone of the core institutions discussed above. Where should they start?

One area of emphasis should be institutions that must be homegrownand can precede market development. That effort can begin with honestcourts, regulators, and prosecutors, which are critical whatever form a coun-try’s capital markets take. And government honesty is important for morethan just capital markets development.

A second good starting point is good capital markets rules. Investor-protective rules are only part of the framework that supports securities mar-kets, but they can perhaps speed the development of other elements of thisframework. Moreover, these rules can, in significant part, be imported fromoutside. But the importing country needs to understand that if it engagesfive sets of foreign advisors, they will propose five different laws, which willbe inconsistent with each other and with the country’s existing laws. Localdraftsmen need to be closely involved in the drafting process, to ensure thatthe rules fit into the existing legal framework and build on existing termi-nology and practice to the extent possible. Done right, this is a multiyearprocess. Many countries rush it and botch the job, thereby lengthening thetime period before they in fact develop good rules.98

Accounting rules are a central part of information disclosure. Here,the International Accounting Standards Committee is not far from com-pleting a workable set of International Accounting Standards that countriescan draw on in preparing their own rules, or even adopt wholesale.

Another important long-term step, if reputational intermediaries areweak or few in number, is to establish or strengthen business schools (forinvestment bankers and accountants) and law schools (for securities lawyersand regulators). The payoff from training young people will be measured indecades. But if the investment isn’t made, the decades will go by, and thecountry still won’t have the prerequisites it needs. Significant piggybackingis feasible here—a country can establish a program (perhaps with foreignaid funding) to send top students to foreign professional schools.

In developed countries, scholars often think of good corporate govern-ance as revolving around subtle variations in director independence, theexistence and role of the audit committee, constraints on the corporate

98. On the importance of local adaptation and understanding of rules imported from out-

side, see DANIEL BERKOWITZ, KATHARINA PISTOR & JEAN-FRANCOIS RICHARD, ECONOMICDEVELOPMENT, LEGALITY, AND THE TRANSPLANT EFFECT (working paper, 1999), available athttp://papers.ssrn.com/paper.taf?abstract_id=183269 (Social Science Research Network). Formy own efforts to adapt the principles discussed in this Article to concrete contexts, see Black(2001), supra note 46, and Black, Metzger, O’Brien & Shin (2001), supra note 10.


control market, and the like. In developing countries, corporate govern-ance is often much more basic. These countries need honest judges andregulators, good disclosure rules, and the beginnings of a culture of honestybefore it makes sense to worry whether public company boards have, say, amajority of independent directors.

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Economy & Finance

The legal and institutional preconditions for strong securities market