LEGAL PROTECTIONS FOR INVESTORS: A PRIORITY FOR THE HEMISPHERE
Allan Roth [*]
Introduction
In connection with the goal to “promote further legal convergence in the area of inter-American business transactions” (SLA/OAS-CIDA Project Background Paper), this paper addresses the needs in the area of investor rights. For reasons stated in the body of the paper, the focus is on the capital market and the protection of investors in shares.
The modern corporation depends on a healthy capital market in order to meet the competitive needs of a global society, and investors in the capital market depend on adequate legal protections in order to participate in the capital market. Investor protections may take many forms, and it is important to assure that the forms adopted are effective and are perceived as effective by the investors themselves. What should be the goals of the OAS member states in strengthening those protections throughout the hemisphere?
Laws Protecting Investors are Important for Economic Development and Growth
It is well established that a country’s financial system plays a key role in its economic growth and stability. It is also acknowledged that the capital market is a key part of any financial system.[1] Scholars generally agree that the size and breadth of the capital market affects economic development and growth.[2] As noted in a recent scholarly paper:[3]
* * * In countries with strong shareholder protection, investors can afford to take minority positions rather than controlling stakes. As a result, firms tend to have dispersed shareholders as owners, and capital markets are rather liquid. By contrast, where shareholder rights are not well protected, investors will compensate this deficiency by taking controlling stakes. This leads to high levels of ownership concentration.
In addition to studies from a macroeconomic vantage, research shows that financial market development is especially important for small firms and for the formation of new enterprises. Inadequately developed financial systems also hinder large firms by limiting the availability of long-term capital.[4] Well functioning financial markets facilitate access to external funds for firms with good investment opportunities. The resulting improved efficiency in the capital allocation process enhances economic growth.[5]
Extensive research by economists and lawyers confirms the significant impact that law and legal institutions have on the financial system’s development and growth. The Nobel laureate Douglass C. North,[6] highlighting the important relationship between a country’s legal institutions and its economic development, emphasized that secure property rights are critical for capital markets to develop and flourish. In turn, secure property rights “require political and judicial organizations that effectively and impartially enforce contracts across space and time.”[7] In the words of one scholarly study:[8]
* * * [T]he legal rights of outside investors and the efficiency of the legal system in enforcing those legal rights is strongly and positively linked with GDP growth, industrial performance, new firm formation, and firm growth. The legal system importantly influences financial sector development and this in turn influences firm performance, the formation of new firms, and national growth rates.
They conclude that “policy makers should . . . focus on strengthening the rights of outside investors and enhancing the efficiency of contract enforcement.”[9]
Of particular interest is a series of studies conducted by Professors Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Schleifer and Robert Vishny that highlight the importance of legal protections for investors.[10] A 1996 study concluded that the effectiveness of a financial system is correlated to the legal rules protecting investors and the quality of the enforcement of those rules.[11] In the words of the authors [emphasis in the original]:
The rights attached to securities become tremendously important once it is recognized that managers of companies act in their own interest. Investors’ rights give them the power to extract from these managers the returns on their investment. Thus shareholders receive dividends because they can vote out the directors who do not pay them, and creditors are paid because they have the power to repossess collateral. Without these rights, investors would not be able to get paid, and therefore firms would not have the benefit of raising funds from these investors. The rights attached to securities are what managers and entrepreneurs give up to get finance.
But the view that securities are inherently characterized by some intrinsic rights is incomplete as well. It ignores the obvious point that these rights depend on the legal rules of the jurisdictions where these securities are issued. Does being a shareholder in France give an investor the same privileges as being a shareholder in the United States, India, or Mexico? Would a secured creditor in Germany fare as well when the borrower defaults as one in Taiwan or Italy, assuming that the value of the collateral is the same in all cases? Law and the quality of its enforcement are potentially important determinants of what rights security holders have and how well these rights are protected. Since the protection investors receive determines their readiness to finance firms, corporate finance may critically turn on these legal rules and their enforcement.
In a succeeding study,[12] the same scholars compared a sample of 49 countries according to a measure of the quality of legal protections for investors and of law enforcement in those countries. They concluded that the “legal environment has large effects on the size and breadth of capital markets across countries.”[13] In the absence of effective legal protections, the capital market does not attract small, diversified investors.
Summarizing the various reported research, a recent World Bank working paper concluded[14]:
* * * Economies grow faster, industries depending heavily on external finance expand at higher rates, new firms are created more easily, firms’ access to external financing is higher, and firms grow more rapidly in economies with a higher levels [sic] of overall financial sector development and in countries with legal systems that more effectively protect the rights of outside investors.
The Modern Corporation is Dependent on a Developed Capital Market
The limited liability enterprise, or “corporation”, is designed to facilitate raising capital from outside investors. The attribute of limited liability for the investors is designed to encourage strangers to the enterprise to contribute capital. The governance structure of the corporation is designed to allow a separation of management and ownership and for the professionalization of management.
The modern corporation requires outside capital to achieve optimum levels of efficiency and to meet the needs of global competition. The absence of effective financial markets creates distortions in the economy that reduce competitiveness. For example, in one country in which the author served as a technical advisor, businesses—especially small- and medium-sized businesses-lacked sources of long-term capital. Some of the resulting distortions were noted by the author as follows:
Business firms--both large and small--tend to rely heavily on internal financing. Managers of several firms with whom we spoke were proud of the low external debt carried by their firms. This means that capital expansion is either to be financed by retained earnings, rolled-over bank overdrafts or some combination of the two. This can be expected to inhibit managements from expanding the scale of their operations, with the result that firms may not achieve optimum scales of operations to maximize efficiencies. Alternatively, the need to generate investment capital from earnings impels managers to set high profit margins--which seems a common practice--with the result that prices are high. When coupled with the pressure on management to pay a large percentage of earnings as dividends, this pressure to generate high levels of profits to provide working capital and expansion capital is accentuated.
Investors are more inclined to provide the needed capital where they are afforded adequate legal protections. La Porta et al find that that “the [legal] protection investors receive determines their readiness to finance firms,” and they show that the legal environment significantly affects the size and breadth of capital markets across countries.[15] By diminishing financing constraints, effective legal protection allows for more efficient capital allocation.
Civil and Common Law Distinctions
The research of Professors La Porta, Lopez-de-Silanes, Shleifer and Vishny indicates that investor protections are stronger and more effective in common law countries than in the civil law countries. [16] They also examined the quality of the enforcement of the laws to protect investor in various countries, considering the quality of enforcement in terms of the efficiency of the judiciary and the quality of accounting standards. From this examination, they concluded that while enforcement generally is more effective in affluent countries than in economically less developed countries, countries following the French civil law tradition have the “worst quality of law enforcement” among the groups of legal systems studied.[17] In short, the type of legal system appears more important to the effectiveness of legal protections for investors than the level of economic development.
The reason for the disparity between common law and civil law countries in the quality and effectiveness of investor protections is speculative. These scholars suggest two lines of analysis: Judicial and political.[18]
The judicial explanation is that judge-made law is inherent in common law systems, and judges are at liberty to evolve new standards of conduct in the face of new types of behavior by corporate managers and other insiders. Civil law judges are more constrained in evolving new standards since they are dependent upon the legislature to initiate the formulation of rules and standards. The common law judges, then, are more pro-active on behalf of investor protections than their civil law counterparts.
The political explanation focuses on the differences in the historical development of the countries that originated the common and civil law traditions. In England, where the Crown gradually lost power over the courts to Parliament and the landed interests, the judges perceived their role to be the protectors of private rights against interference by the Crown. In France and Germany, it is argued, the kings were never dominated by the legislature, and the state interest continued to dominate the courts. Civil law courts, therefore, were less likely than common law courts to side with investors over the state or the commercial interests aligned with the state.[19]
The conclusion of this research is that “the nature of investor protection, and of regulation of financial markets more generally, is deeply rooted in the legal structure of each country, and in the origin of its laws. Reform on the margin may not successfully achieve the reformer’s goals.”[20]
Those who would reform the laws providing investor protection must be mindful of these factors. Not only must the text of the law be changed, but the attitudes of lawyers and judges must be influenced to embrace the changes and the underlying reasons for them.
What should be the Goals of the OAS Member States in Strengthening Investor Protections throughout the Hemisphere?
As national borders become less relevant to financial markets and investment, the laws and practices by which those markets are structured are becoming more integrated. One need point only to the European Union's harmonization of securities laws, the growing influence of the International Organization of Securities Commissions, the United States‑Canadian Multijurisdictional Disclosure System and the WTO Understanding on Trade in Financial Services to highlight the transnationality of financial markets and institutions. Indeed, one commentator has suggested that domestic laws regarding securities disclosure should be replaced “with unified disclosure standards to be used by domestic and foreign issuers in all developed markets.”[21]
At one time, it was feared that freely allowing borders to be crossed would result in a “race to the bottom” by regulators;[22] business would flock to the jurisdiction that had the least regulation. That view has given way to the opposite expectation; experience has not borne out the prediction of a race to the bottom. Because effective regulation produces more efficient markets, competitive forces make the more regulated jurisdictions more attractive, not less. Professor Coffee, for example, suggests that foreign companies eagerly submit to the world’s most rigorous securities laws to gain the economic advantages of the U.S. market.[23]
It is thus in the interests of the OAS member states to strengthen their respective laws providing protections for investors. Indeed, over the past three decades, vigorous efforts at strengthening these laws have been made in a number of member countries. It is now time to coordinate this effort on a multinational basis to facilitate cross-border investment and enhance economic growth domestically and regionally. The OAS could provide the impetus for this effort.
If there is to be some effort to integrate or coordinate the investor protective laws in the OAS member states, there are choices to be made. Since investor protections have been demonstrated to be so critical to economic development, it would follow that the countries with the most effective investor protective laws would have a competitive advantage. Other countries would want to improve their legal protections for investors to equalize their competitive positions. This is the reasoning of those who urge “convergence” of law.[24]
Convergence has been described as a “dynamic of institutional change” whereby “competition between systems and institutions will over time self-select the most effective institutions, and different systems will converge on these.”[25] A counter view is that “institutions develop along path dependent trajectories. Institutional change is incremental and shaped by pre-existing conditions. Thus, systems will continue to diverge rather than converge.”[26] Both are essentially reactive strategies - how will institutions develop if left on their own.
A more pro-active approach could be through “harmonization” of laws. Harmonization may be through reciprocity or commonality (uniformity). Using disclosure requirements to illustrate the point, with reciprocity, if the disclosure satisfies the requirements of the home country, it will be acceptable in the host country. With commonality, all countries strive to achieve agreed upon standards and procedures for disclosure.
The European Union has used both.[27] Through a series of directives for member countries to adopt basic provisions in their laws, the EU has set minimum standards for the entire common market.[28] Each member is free to adopt more extensive or stringent requirements, but the minimum standards assure a level of investor protection that is acceptable to all members. This is the commonality element.