11-05-11 Black - The Legal and Institutional Foundations For Strong Capital Markets

THE LEGAL AND INSTITUTIONAL PRECONDITIONS
FOR 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 and
other securities. A strong securities market rests on a complex network of legal
and market institutions that ensure that minority shareholders (1) receive good
information about the value of a company’s business and (2) have confidence
that a company’s managers and controlling shareholders won’t cheat them out of
most or all of the value of their investment. A country whose laws and related
institutions fail on either count cannot develop a strong securities market, forcing
firms to rely on internal financing or bank financing—both of which have impor-
tant shortcomings. In this Article, Professor Bernard Black explains why these
two investor protection issues are critical, related, and hard to solve. He dis-
cusses which laws and institutions are most important for each, which of these
laws and institutions can be borrowed from countries with strong securities mar-
kets, and which must be homegrown.
INTRODUCTION............................................................................................................. 782
I. INFORMATION ASYMMETRY BARRIERS
TO SECURITIES OFFERINGS .................................................................................... 786
A. Information Asymmetry and the Role
of Reputational Intermediaries ...................................................................... 786
B. The Core Institutions that Control
Information Asymmetry ................................................................................ 789
C. Additional Useful and Specialized Institutions............................................. 799
1. Useful Institutions.................................................................................. 799
* I thank the Organisation for Economic Co-operation and Development (OECD) for
financial support. I thank John Coffee, Rob Daines, David Ellerman, Ron Gilson, Jeff Gordon, Peter
Henry, Steven Huddart, Cally Jordan, Ehud Kamar, Michael Klausner, Ross Levine, Amir Licht,
William Megginson, Jamal Munshi, and participants in an OECD conference on Corporate
Governance in Asia, an International Monetary Fund workshop on Comparative Corporate
Governance in Developing and Transition Economies, the UCLA School of Law First Annual
Corporate Governance Conference, and workshops at the American Law & Economics
Association, Brazil Securities Commission, Brazil Stock Exchange, Korean Securities Law
Association, Seoul National University School of Business, Stanford Law School, University of
Missouri-Columbia Law School, and University of Sao Paolo Law Faculty for helpful comments
and suggestions. An earlier and shorter version of this Article was published as The Core
Institutions that Support Strong Securities Markets, 55 BUS. LAW. 1565 (2000). The research for this
Article was substantially completed as of October 2000. The citation style used in this Article
departs in some cases from the Bluebook citation system.
781
782 48 UCLA LAW REVIEW 781 (2001)
2. Specialized Institutions .......................................................................... 801

D. Which Institutions Are Necessary, Which Are Merely
Nice to Have? ................................................................................................ 803
II. PROTECTING MINORITY INVESTORS AGAINST SELF-DEALING.............................. 804
A. Self-Dealing as an Adverse
Selection/Moral Hazard Problem .................................................................. 804
B. The Core Institutions that Control Self-Dealing.......................................... 806
C. Additional Useful and Specialized Institutions............................................. 814
III. PIGGYBACKING ON OTHER COUNTRIES’ INSTITUTIONS........................................ 816
A. Estimating the Ease of Piggybacking ............................................................. 816
B. Can Substitute Institutions Facilitate Piggybacking? .................................... 830
IV. EMPIRICAL EVIDENCE ............................................................................................ 831
A. The Qualitative Case for Strong Securities Markets..................................... 832
B. Empirical Evidence: Investor Protection and Strong
Capital Markets ............................................................................................. 834
C. Empirical Evidence: Investor Protection, Capital Markets,
and Economic Growth .................................................................................. 835
V. STRONG AND WEAK SECURITIES MARKETS: A
SEPARATING EQUILIBRIUM?................................................................................... 838
VI. IMPLICATIONS ....................................................................................................... 841
A. Different Types of Monitoring: Investor Protection
and Firm Performance ................................................................................... 841
B. Competition Between Securities Regulators ................................................. 843
C. Convergence in Capital Markets
and Corporate Governance ........................................................................... 845
CONCLUSION: WHAT STEPS TO TAKE FIRST ................................................................ 847
REFERENCES .................................................................................................................. 849
INTRODUCTION
A strong public securities market, especially a public stock market, can

facilitate economic growth. But creating strong public securities markets is
hard. That securities markets exist at all is magical, in a way. Investors pay
enormous amounts of money to strangers for completely intangible rights,
whose value depends entirely on the quality of the information that the
investors receive and on the sellers’ honesty.
Internationally, this magic is rare. It does not appear in unregulated
markets. Aggressive efforts to mass privatize state-owned enterprises and
create stock markets overnight, in formerly centrally planned economies
like 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, Simon
Johnson & 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 strong
securities markets. Russia, for example, has pretty good laws in theory, but
miserable 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 essential
for strong securities markets. My goals are threefold: first, to explain the
complex network of interrelated legal and market institutions that supports
strong markets in countries, like the United States and the United Kingdom,
that have these markets; second, to offer a guide to reforms that can
strengthen securities markets in other countries; and third, to offer some
cautionary words about the difficulty of creating this complex network of
institutions, and the impossibility of doing so quickly. I also survey the
empirical evidence on the correlation between investor protection and
securities markets, and between securities markets and economic growth.2
I argue here that there are two essential prerequisites for strong public
securities markets. A country’s laws and related institutions must give minor-
ity shareholders: (1) good information about the value of a company’s
business; and (2) confidence that the company’s insiders (its managers and
controlling shareholders) won’t cheat investors out of most or all of the
value of their investment through “self-dealing” transactions (transactions
between a company and its insiders or another firm that the insiders
control) 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 provide
capital to growing firms, though still no certainty of developing such a
market.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 & Reinier
Kraakman, 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 Corporate
Governance 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 it
doesn’t significantly constrain the private contractual arrangements that a company’s shareholders
can choose for themselves. Some readers of this Article have commented on the tension between
the views expressed here and those expressed in my earlier article. A short answer is that I did not
claim then that all of securities law (as opposed to corporate law) was trivial, and I would find less
of securities law trivial today than I might have then. See id. at 565 (questioning the importance
of some securities rules, but recognizing that “federal [securities] rules are an important source of
nontrivial corporate law”).
784 48 UCLA LAW REVIEW 781 (2001)
institutions and following that country’s rules. But only partial escape is
possible. A company’s reputation is strongly affected by the reputations of
other firms in the same country. And reputation unsupported by local
enforcement and other local institutions isn’t nearly as valuable as the same
reputation buttressed by those institutions.
I don’t address here a third aspect of corporate governance—how good
a country’s institutions are at ensuring that managers are competent and
seek to maximize profits rather than (say) firm size or their own prestige.
Corporate governance debates in the United States and other developed
countries often revolve around this “value maximization” issue. But for
most countries, I believe, value maximization is worth worrying about only
after the more basic disclosure and self-dealing issues are addressed. Moreover,
I know of no countries that have good financial disclosure and good control
of 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 equilibria
to exist. In the first “lemons” equilibrium, most honest companies don’t
issue shares to the public because weak investor protection prevents them
from realizing a fair price for their shares. This decreases the average quality
of the shares that are issued, which further depresses prices and discourages
honest issuers from issuing shares. Political demand for stronger investor
protection is muted by the relative scarcity of outside investors. In the sec-
ond “strong markets” equilibrium, strong investor protection produces high
prices, which encourage honest companies to issue shares. This increases the
average quality of the shares that are issued, which further increases share
prices and encourages more honest issuers to issue shares. Outside investors
then generate political support for strong investor protection. This Article
can be seen as an attempt to develop minimum conditions for the “strong
markets” equilibrium.
The analysis developed here can inform several current corporate gov-
ernance debates. The first debate concerns the merits of bank-centered
versus 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 concern

are: First, unless managers know (and investors don’t) whether the managers are maximizing
profits, good management does not have the adverse selection structure of disclosure, nor the
combined adverse selection/moral hazard structure of self-dealing. It therefore doesn’t prevent
honest 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 increase
managers’ private returns from a value maximizing strategy.
market-centered markets offer liquidity but weaker monitoring. I argue here

that stock-market-centered capital markets provide strong information
disclosure and control of self-dealing—monitoring dimensions for which
bank-centered capital markets are often weaker.5 Moreover, the standard
debate compares strong bank-centered capital markets to strong stock-
market-centered capital markets. It overlooks the many institutions that are
common 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 competition
between securities regulators. If strong securities markets depend on a com-
plex network of market and government institutions, then the debate is
largely misplaced. Competition between securities regulators simply cannot
exist 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 national
corporate governance systems. The institutions that support securities
markets coevolve and reinforce each other. Weakness in one can sometimes
be offset by strength in another. Formal legal rules are only part of a large
web of market-supporting institutions. This suggests that convergence will
sometimes be functional (different countries use different institutions to
accomplish similar tasks) rather than formal (different countries adopt
similar rules).
I address the prerequisites for a strong securities market in the context
in which they are most acute—a public offering of common shares, often by
a company that is selling shares to the public for the first time. Similar
though less acute issues arise when companies issue debt securities.
Part I of this Article explains why controlling information asymmetry
is critical for developing strong public stock markets and discusses which
laws and institutions are most important in doing so. Part II explains why
controlling self-dealing is also critical and discusses the somewhat different
laws and institutions that are central for this task. Part III explores the
extent to which companies can escape weak domestic laws and institutions
by relying on foreign rules and institutions. Part IV discusses the empirical
evidence 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 SOCIAL
DEMOCRACY (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 arguing
that the large number of public American firms reflects U.S. success in controlling agency costs).
786 48 UCLA LAW REVIEW 781 (2001)
or a strong market equilibrium. Part VI develops the implications of my

analysis for the monitoring strengths of stock-market-centered and bank-
centered capital markets, competition among securities regulators, and the
convergence of corporate governance systems. I conclude by discussing
which 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 and

public investors is asymmetric information. The value of a company’s shares
depends on the company’s future prospects. The company’s past perform-
ance is an important guide to future prospects. The company’s insiders know
about both past performance and future prospects. They need to deliver this
information 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’s
performance and prospects, and investors can’t directly verify the information
that 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 reputation
to signal the quality of the information that it provides.
In economic jargon, securities markets are a vivid example of a market
for lemons.6 Indeed, they are a far more vivid example than George Akerlof’s
original example of used cars. Used car buyers can observe the car, take a
test drive, have a mechanic inspect the car, and ask others about their
experiences with the same car model or manufacturer. By comparison, a
company’s shares, when the company first goes public, are like an unob-
servable car, produced by an unknown manufacturer, on which investors
can obtain only dry, written information that they can’t directly verify.
Investors don’t know which companies are truthful and which aren’t, so
they discount the prices they will offer for the shares of all companies. These
discounts may ensure that investors receive a fair price, on average. But
consider the plight of an “honest” company—a company whose insiders report
truthfully to investors and won’t divert the company’s income stream to
themselves.
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 fair
value 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’t
worth the paper they’re printed on are, after all, quite cheap to produce. The
tendency for high-quality issuers to leave the market because they can’t
obtain a fair price for their shares, while low-quality issuers remain, worsens
the lemons (adverse selection) problem faced by investors. Investors ration-
ally react to the lower average quality of issuers by discounting still more the
prices they will pay. This drives even more high-quality issuers out of the
market and exacerbates adverse selection.
Some countries, including the United States, have partially solved this
information asymmetry problem through a complex set of laws and private
and public institutions that give investors reasonable assurance that the
issuer is being (mostly) truthful. Among the most important institutions
are reputational intermediaries—accounting firms, investment banking
firms, law firms, and stock exchanges. These intermediaries can credibly
vouch for the quality of particular securities because they are repeat players
who will suffer a reputational loss, if they let a company falsify or unduly
exaggerate its prospects, that exceeds their one-time gain from permitting
the exaggeration. The intermediaries’ backbones are stiffened by liability to
investors if they endorse faulty disclosure, and by possible government civil
or criminal prosecution if they do so intentionally.7
But even in the United States, “securities fraud”—the effort to sell
shares at an inflated price through false or misleading disclosure—is a major
problem, especially for small issuers. Attempts by skilled con artists to sell
fraudulent securities are endemic partly because the United States’ very
success 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 to
be prepared by securities counsel. It helps if the issuer is listed on a reputable
stock exchange. But investors’ reliance on reputational intermediaries
merely re-creates the fraud problem one step removed. An environment in
which most reputational intermediaries guard their reputations creates
an opportunity for new entrants to pretend to be reputational inter-
mediaries. Merely calling oneself an investment banker will engender some
7. I use the terms “accountants” and “accounting firms” to include the auditing function that
accountants and accounting firms perform. But I refer separately to “accounting rules” and “auditing
standards.” 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).
788 48 UCLA LAW REVIEW 781 (2001)
investor trust, because most investment bankers are honest and care about
their reputations. Investors (rationally) won’t fully investigate investment
bankers’ claims to have strong reputations. The other key intermediaries—
accountants and securities lawyers—can similarly trade on their profession’s
reputation (notwithstanding the occasional snide joke about whether that
reputation is deserved).
In the language of welfare economics, investment banking (or account-
ing or securities lawyering) involves an externality—any one participant
can’t fully capture its own investment in reputation. Some of the invest-
ment enhances the reputation of the entire profession. That externality
reduces incentives to invest in reputation. And new entrants can free ride
on 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 “bogus
investment bankers”—to call themselves investment bankers, intending to
profit by pretending that their recommendation of a company’s shares has
value. In effect, bogus investment bankers steal some of the value of their
competitors’ reputations, while also devaluing those reputations, because
bad reputations spill over to the rest of the profession just as good ones do.
The result is ironic: The principal role of reputational intermediaries is
to vouch for disclosure quality and thereby reduce information asymmetry
in 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 somewhat
stronger solution is mandatory self-regulatory organizations. In the United
States, for example, investment bankers must belong to either the New
York Stock Exchange or the National Association of Securities Dealers. A
member evicted by one is unlikely to be accepted by the other. Thus, a
mandatory SRO can put a misbehaving member out of business, not merely
deprive 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 large
externalities 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 deciding
whether 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. This
suggests a business opportunity for the major world exchanges: Companies from countries with
weak domestic institutions need reputational enhancement. Close exchange oversight could attract
those 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 SRO
to vouch for their quality, and investors will then have to figure out whether
the SRO is itself a bogus intermediary.9
A third solution combines liability of the intermediaries to investors
with minimum quality standards for intermediaries. Regulators license the
intermediaries, 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 the
ability to collectivize the cost of enforcement (by spreading the cost of pri-
vate enforcement through a class action or derivative suit, and the cost of
public enforcement through taxes), may explain why liability and licensing
strategies mostly dominate over second-tier reputational intermediaries.
The resulting system, in which multiple reputational intermediaries
vouch for different aspects of a company’s disclosure, while the government,
private plaintiffs, and self-regulatory organizations police the reputational
intermediaries, can work fairly well. But it is scarcely simple. And it may
require ongoing government effort to protect reputational intermediaries
against bogus intermediaries who would otherwise profit from the spillover
of reputation to them.
This complex response to information asymmetry goes a long way toward
explaining why many nations have not solved this problem. Their
securities 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 share
prices toward zero. In these countries, a few large companies can develop
reputations sufficient to justify a public offering of shares at a price that,
though below fair value, is still attractive compared to other financing
options. But smaller companies have essentially no direct access to public
investors’ capital.
B. The Core Institutions that Control Information Asymmetry
Countries with strong securities markets have developed a number

of institutions to counter information asymmetry. I list below the “core”
institutions that I consider most important. This list reflects my personal
judgment, 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 themselves
engaged in tunnelling and opposed strong self-regulation”).
790 48 UCLA LAW REVIEW 781 (2001)
in a variety of countries.10 I present the list in an order that makes logical

sense, not in order of estimated importance. Part III combines this list and
the related list of core institutions that control self-dealing into a single
table.
Effective Regulators, Prosecutors, and Courts
(1) A securities regulator (and, for criminal cases, a prosecutor) that: (a) is
honest; and (b) has the staff, skill, and budget to pursue complex securities disclo-
sure cases.
Honest, decently funded regulators and prosecutors are essential. They
tend to be taken for granted in developed countries, but are often partly or
wholly absent in developing countries. Funding is often a hidden problem.
The securities regulator may have a minimal budget, or may be hamstrung
by 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 inventory
that don’t exist. An unspecialized prosecutor could potentially bring these
cases, but may prefer to prosecute muggers and murderers instead.
Moreover, many securities fraud cases require careful digging through the
company’s records to show how the insiders have twisted the truth, and skill
to present the fraud in convincing fashion to a court. And the insiders often
have 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 prevent
asset stripping; and (d) produces decisions without intolerable delay.
An honest judiciary is a must for investor remedies to be meaningful, but
is often partly or wholly absent in developing countries. Decent judicial
salaries 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 Moo
Shin, 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 at
http://papers.ssrn.com/paper.taf?abstract_id=222491 (Social Science Research Network); Bernard
S. 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 prosecutors
require sophisticated judges. The ideal would be a specialized court, staffed
by judges with prior experience as transactional lawyers. A court in a com-
mercial center, which sees a steady diet of business cases, is an acceptable
substitute.
Speed is important too. When insiders commit fraud, some funds can
sometimes be retrieved if the prosecutors can freeze the insiders’ assets
pending the outcome of a case that the prosecutors plan to bring. Other-
wise, the money is usually as good as gone. Beyond that, while courts
nowhere move quickly, differences in how fast they move affect the salience
of investor remedies. Moreover, many countries award no or inadequate
interest 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 intermediaries
depends in important part on procedural rules that provide reasonably
broad civil discovery. Proving misdisclosure often requires information that
is buried in the company’s records. Also, an individual investor won’t often
incur 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 combine
many 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 bankrupt
after selling oil to Sidanko, which failed to pay for the oil and then was looted so badly that it
went bankrupt itself. In the Chernogoneft bankruptcy proceedings, 98 percent of the creditors
voted for one external manager, but the local judge appointed a different manager with ties to a
Sidanko 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 Sidanko
chairman 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. See
Rules of War, ECONOMIST, Dec. 4, 1999, at 65; Jeanne Whalen & Bhushan Bahree, How Siberian
Oil 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 to
a minority shareholder in Kondpetroleum (a second Sidanko subsidiary) in litigation against Sidanko
and 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 the
incentive for good disclosure. For discussion of Taiwan’s substitute for a securities class action, see
Lawrence S. Liu, Simulating Securities Class Actions: The Case in Taiwan, CORP. GOVERNANCE INT’L,
Dec. 2000, at 4.
792 48 UCLA LAW REVIEW 781 (2001)
Financial Disclosure
(4) Extensive financial disclosure, including independent audits of public

companies’ financial statements.
A stock market can’t thrive unless listed companies provide investors
with audited financial statements. The risk of fraudulent or seriously mis-
leading financial statements is too great. Audited financial statements provide
a 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 question
that I need not address here. This custom can emerge through stock exchange
13
rule or common practice, as it did in the United States. But a mandatory
rule might speed up this process. The case for mandatory audits and com-
pliance with a defined set of accounting rules becomes stronger, the weaker
a country’s reputational intermediaries (who can police the disclosure) and
disclosure culture are.14
(5) Accounting and auditing rules that address investors’ need for reliable
information.
Good accounting rules should be designed to provide information
useful to investors. This sounds obvious, but in many countries, accounting
rules are designed as much to facilitate tax collection as to inform investors
15
about value. 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 alternative
accounting 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, 83
VA. L. REV. 1509 (1997); cf. Brian Cheffins, Does Law Matter?: The Separation of Ownership and
Control 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 London
Stock Exchange disclosure rules, which often preceded statutory requirements).
14. For pieces of the mandatory disclosure debate, see FRANK H. EASTERBROOK & DANIEL
R. 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 Mandatory
Disclosure System, 70 VA. L. REV. 717 (1984); Paul G. Mahoney, Mandatory Disclosure as a Solution to
Agency 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 Standards
for precisely this reason. See Interview with Sergey Shatalov, First Deputy Minister of Finance, in
No 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 tax
purposes”).
Stricter rules aren’t always better. The accounting rules must strike a
sensible balance among investors’ desire for information, the cost of providing
the 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 between
companies and investors.
Auditing standards must be rigorous enough to catch some of the out-
right frauds that occur, deter many potential fraud attempts, and discourage
at least some attempts at creative accounting.
(6) A rule-writing institution with the competence, independence, and
incentives 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 the
business. Thus, the rule-writing task is best placed elsewhere—in a securities
commission or perhaps, as in the United States and Great Britain, in a quasi-
public organization that is loosely supervised by the securities commission
or 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 incentive
to write new rules and interpret old ones with reasonable dispatch.17 This
offers some reason to vest rule writing in a quasi-public organization, rather
than a government agency. If the rule-writing body is private, its funding and
the manner of choosing its members must ensure that the agency isn’t overly
dependent 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 to

catch 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 business
practices, see Louis Lowenstein, Financial Transparency and Corporate Governance: You Manage
What You Measure, 96 COLUM. L. REV. 1335 (1996).
794 48 UCLA LAW REVIEW 781 (2001)
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 a
more flattering portrait is a true one, and can replace an artist who paints
too unflattering a portrait. Moreover, a minority of subjects are crooks who
will do whatever they can to mislead the artist and thus the investors who
will later view the portrait.
Professionalism is essential—to see the truth that the subject may try to
conceal and to resist the subject’s pressure for an overly flattering portrait—
if the portrait is to resemble reality and be comparable to other portraits
painted 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 statements
so that the accountants will resist their clients’ pressure for laxer audits or more
favorable disclosure.
Accountants are reputational intermediaries. When they audit and
approve financial statements, they also rent out their reputations for con-
ducting a careful audit that can catch some fraud and discourage attempts
at fraud, and for painting a tolerably accurate picture of a company’s
performance.
Liability risk reinforces the accounting firm’s concern for reputation.
It can persuade the firm to establish internal procedures to ensure that the
financial 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 firm
proposes.
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 which
result in a significant payout (in settlement or after a verdict), are enough.
But without any liability risk, accounting firm partners will sometimes accept
the ever-present temptation to squander the firm’s reputation to gain or
keep 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 at
below-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 financial
statements disclosed mildly that these transactions “may” give rise to some liability by the controlling
shareholder to the company, with no mention of the amount (which was in the hundreds of
millions of dollars). A reputable accounting firm would never bless this paltry disclosure if it faced
meaningful liability to investors.
(9) A sophisticated investment banking profession that investigates securities

issuers because the investment banker’s reputation depends on not selling overpriced
securities to investors.
Investment bankers are a second key reputational intermediary. They
walk a fine line between selling an offering and overselling it. Their role
includes conducting a “due diligence” investigation of the issuer and satis-
fying themselves that the offering documents and “road show” presentations
reasonably portray the issuer’s prospects, the major risks of the investment
are disclosed, and the issuer’s managers are honest. For example, investment
banks routinely conduct background checks on company insiders and walk
away 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 bad
investments and avoid its future offerings. Investment banks track the after-
market performance of their own and their competitors’ offerings and happily
disclose competitors’ weak performance to potential clients. And when an
underwriter sells shares for a fraudulent company, which later collapse
in price when the fraud is discovered, this is a major embarrassment, not
soon forgotten by investors or the bank’s competitors. So too for a debt
offering that quickly goes into default.
(10) Securities or other laws that impose on investment bankers enough risk
of liability to investors if the investment bankers underwrite securities that are sold
with 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 for
reputation. 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. And
liability risk provides a compelling argument that the investment bank can
offer to a client that wants more favorable disclosure than the bank proposes.
As for accountants, I make no claim that frequent litigation against
investment bankers is important. A few lawsuits per decade, a couple of
which 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-present
temptation to squander the firm’s reputation to gain a client and a fee.
(11) Sophisticated securities lawyers who can ensure that a company’s
offering documents comply with the disclosure requirements.
Securities lawyers are a third major reputational intermediary—albeit
less visible to investors than accountants or investment bankers. They walk
a fine line between accepting the positive-sounding statements that the
issuer wants to make and insisting on the need to disclose risks and problems.
796 48 UCLA LAW REVIEW 781 (2001)
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 hiring
lawyers to write and review the key disclosure documents. The lawyers’
caution (deriving from the need to protect one’s client against liability) will
help 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 disclosure
documents, or reject the lawyers’ cautionary advice, and disclosure quality
will suffer.
(12) A stock exchange with meaningful listing standards and the willingness
to 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. Both
investors and exchanges understand that false disclosure by a few companies
will taint all listed companies. Historically, stock exchange listing rules
were an important factor in the rise of dispersed ownership in the United
States and the United Kingdom.19
Company and Insider Liability
(13) Securities or other laws that impose liability and other civil sanctions
on 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 and
insiders who attempt fraud.
Companies often want to be able to issue shares in the future; insiders
want to be able to sell their shares at an attractive price in the future. That
gives insiders an incentive to develop the company’s reputation for honest
disclosure. But some of the time, the company needs funds now, or there
won’t be a next time. In game theory terms, the insiders are in the final
period of a repeated game. They have an incentive to cheat because there
won’t be a next round in which the cheating can be punished.20 At other
times, the insiders face a final period because their tenure in the company is
19. See Cheffins (2001), supra note 13; JOHN C. COFFEE, JR., THE RISE OF DISPERSED
OWNERSHIP: THE ROLE OF LAW IN THE SEPARATION OF OWNERSHIP AND CONTROL (Columbia
Law 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 then
hope to sell another company’s shares the next time.
Insiders’ incentives to puff their company’s prospects help to explain
the universal use in public offerings of reputational intermediaries, who
investigate and vouch for the company’s disclosure. Just as liability to
investors helps to ensure that reputational intermediaries behave as they are
supposed to, this liability helps to ensure that insiders disclose honestly in
the 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 outside
their 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 than
one, won’t adequately deter crooks from attempting fraud in the first
instance. That makes criminal sanctions a critical supplement to financial
liability. At the same time, formal criminal sanctions are of little value
without skilled prosecutors who can bring complex securities cases.
Market Transparency
(15) Rules ensuring market “transparency”: the time, quantity, and price
of trades in public securities must be promptly disclosed to investors.
One key source of information about value that investors rely on is the
prices paid by other investors for the same securities. Investors then know
that others share their opinions about value. Transparency is a collective
good that must be established by regulation. Large investors prefer to hide
their transactions to reduce the price impact that their trades have. Some-
times a stock exchange will have enough market power to force all trades to
be reported to it. More commonly, the government must mandate prompt
reporting and require all trades to be reported in a single consolidated
source, lest exchanges compete for business by offering delayed or no price
reporting.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 can
collect 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 may
dominate 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.
798 48 UCLA LAW REVIEW 781 (2001)
(16) Rules banning manipulation of trading prices (and enforcement of those

rules).
Transparent market prices raise their own dangers. Especially in “thin”
markets, insiders can manipulate trading prices to create the appearance
that a company’s shares are highly valued, while dumping their own shares
on the market. Rules against manipulating trading prices are the principal
response to this risk. These rules need to be enforced by a specialized regu-
22
lator, because manipulation is notoriously hard to prove.
Culture and Other Informal Institutions
(17) An active financial press and securities analysis profession that can
uncover and publicize misleading disclosure and criticize company insiders and
(when appropriate) investment bankers, accountants, and lawyers.
Reputation markets require a mechanism for distributing information
about the performance of companies, insiders, and reputational intermedi-
aries. Disclosure rules help, as do reputational intermediaries’ incentives
to advertise their successes. But intermediaries won’t publicize their own
failures, and investors will discount competitors’ complaints because they
come from a biased source. An active financial press is an important source
of reporting of disclosure failures. But libel laws that make it easy for
insiders to sue their critics (using company funds) can chill reporting. In a
country without honest courts and prosecutors, journalists are vulnerable to
cruder threats as well.23
Security analysts are another important source of coverage. They must
balance the need to maintain a reputation for objectivity against pressure
for positive coverage from companies (who can retaliate for negative cover-
age by cutting off the analyst’s access to soft information), and (for analysts
who 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 Six
Minutes—the Mechanics of Securities Manipulation, 79 CORNELL L. REV. 219 (1994) (criticizing
Fischel and Ross); Omri Yadlin, Is Stock Manipulation Bad?: Questioning the Conventional Wisdom
with Evidence from the Israeli Experience, 3 THEORETICAL INQUIRIES L. (forthcoming 2001). For
Yadlin, it is fine for General Motors to sell shares of Fisher Body in the market, for the purpose of
depressing the trading price so that General Motors can acquire all of Fisher Body at a lower price,
as long as the managers of General Motors believe that Fisher Body’s standalone value is lower
than its market price. The problem is that in any successful manipulation, including those that
Yadlin likes, informed investors profit and uninformed investors lose. Uninformed investing
becomes less profitable, which increases the information asymmetry discount that investors apply
to all shares.
23. For examples of physical retaliation by Russian businessmen against reporters and other
critics, 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, about
any 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 pleasing
companies and their own employers, by rating analysts’ reputations among
investors.24
(18) A culture of disclosure among accountants, investment bankers, law-
yers, and company managers, who learn that concealing bad news is a recipe for
trouble.
In countries with strong securities markets, the sanctions against
misdisclosure reinforce a culture of compliance, in which a bit of puffing
is 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, because
disclosure is the norm and others are occasionally disgraced or sent to jail
for falsifying financial statements.
This long list of institutions underscores the difficult task facing a
country that wants to develop a strong securities market. Formal disclosure
rules are important, but are not enough. The harder task is enforcing the
rules—both direct public enforcement and indirect enforcement through
private institutions, especially reputational intermediaries.
C. Additional Useful and Specialized Institutions
The list of core institutions in Part B reflects my personal judgment

about which rules and institutions are most important for ensuring good
disclosure. This part lists some additional institutions that I consider useful
but not core.
1. Useful Institutions
a. Licensing of reputational intermediaries. It’s useful for accountants

and investment bankers to be subject to a regulatory licensing scheme. I
don’t list regulatory licensing as a core institution because I believe that
for 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, at
109 (rankings available at http://www.iimagazine.com/research/99/aart/best.html). Analysts value
high rankings, which significantly increase their expected income and job mobility. On the role
played by analysts in reducing information asymmetry, see ZOHAR GOSHEN, ON INSIDER
TRADING, MARKETS, AND “NEGATIVE” PROPERTY RIGHTS IN INFORMATION (working paper,
2000).
800 48 UCLA LAW REVIEW 781 (2001)
investors) is likely to be more effective than public enforcement (through

regulatory sanctions). Even in countries with strong regulators, regulatory
sanctions are usually imposed only in egregious cases. Emerging economies
have fewer regulatory resources and better uses for those resources. Prose-
cuting insiders who commit fraud is often a higher priority for regulators
than sanctioning the intermediaries who merely failed to catch the fraud.25
b. Self-regulatory organizations. Self-regulation, through a voluntary or
mandatory self-regulatory organization that is itself subject to regulatory
oversight, is a useful supplement to government regulation of reputational
intermediaries. Just as liability to investors makes reputational intermedi-
aries more willing to insist on good disclosure, it makes the intermediaries
more 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 less
important than for accountants and investment bankers, and hence not
listed above as a core institution. Lawyers are already concerned about
liability because of their training and have an incentive to protect their
clients against liability. Lawyers have reputations to preserve too, and having
clients lose disclosure lawsuits isn’t good for business. But some risk of
liability 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 disclosure
documents. But independent directors can sometimes catch disclosure
problems that the intermediaries miss. The independent directors can be seen
as second-tier reputational intermediaries. Their incentive to review the
disclosure with a skeptical eye can usefully be reinforced by a touch of legal
liability to investors. But the independent directors shouldn’t face too much
liability risk, lest skilled directors refuse to serve. In countries where most
companies have a controlling shareholder, mandatory cumulative voting
can be useful because it allows minority shareholders to elect one or two
truly independent directors, and can strengthen a culture of director
independence.
e. Investment funds and related institutions. Investment funds (Ameri-
cans call them “mutual funds,” for some odd reason) are another useful
institution. They provide individual investors with diversification and some
protection against claims by con artists (who will have a harder time fooling
experts 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 public
enforcement, see Black & Kraakman (1996), supra note 2, at 1929–43.
rities market by providing a source of investable funds, as well as market and

political demand for strong disclosure. I don’t list investment funds as a
core 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 against
self-dealing by the fund managers, a regulator that polices the industry and
limits fund managers’ ability to make inflated claims of past or expected
future performance, and a financial press that rates fund performance.
f. Pension plans. Funded employee pension plans are a further useful
institution. Like investment funds, they are a source of investable funds
and 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. More
generally, private firms can be more aggressive than public firms in tax
planning and outright tax evasion. Thus, high tax rates weaken securities
markets by inducing more firms to stay private. And a high “stamp tax” on
securities transactions can shrink, perhaps dramatically, the size of the secu-
rities market.26
h. Other useful institutions. Even this further list of useful institutions
omits a number of institutions that support an advanced securities market.
Additional institutions include: compliance officers within investment
banks, who help to ensure that investment bankers’ desire for fees won’t
override concern for legal niceties or long-term reputation; an audit com-
mittee of the board of directors, which can give a company’s auditors some
protection against management pressure for lenient treatment; inside
accountants and lawyers, who are acculturated to honest disclosure and
help 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 severe
information asymmetry problems, because these companies often have
short histories, make highly specialized products, participate in fast-moving
26. See COFFEE (2001), supra note 19 (discussing Germany’s 1896 stamp tax); cf. Christopher
J. Green, Paolo Maggioni & Victor Murinde, Regulatory Lessons for Emerging Stock Markets from a
Century of Evidence on Transactions Costs and Share Price Volatility in the London Stock Exchange, 24
J. BANKING & FIN. 577 (2000) (reporting evidence that stamp taxes depress trading volume and
increase volatility).
802 48 UCLA LAW REVIEW 781 (2001)
industries, and have growth prospects (and thus value) that can’t be easily
extrapolated from past financial results. As a result, countries with strong
stock markets, such as the United States, have developed a specialized
institution—the venture capital fund—that funds high-technology com-
panies early in their life and functions in significant part as a specialized
reputational intermediary. Venture capital funds closely investigate com-
panies that seek funding, and then implicitly vouch for these companies
when 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 important
role in providing reputational capital and monitoring. For early stage, high-
technology companies, combining these three services dominates over the
alternative, offered by public securities markets, of providing financial capi-
tal without close monitoring, or the alternative of providing monitoring and
reputational capital without investing, which is a plausible institutional
arrangement that we don’t see.27
If developing a strong public stock market is hard, developing a strong
venture capital industry is harder still. Venture capital funds face a classic
chicken and egg problem in getting started—a venture capitalist can’t get
funding until he develops a reputation for making good investments, but
can’t develop a reputation without making investments. Thus, the initial
stages 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 offer
quality ratings for different issuers. In the United States, rating agencies
more often follow the bond market than lead it. But the rating agencies are
a significant reputational intermediary in less-developed markets, where
they provide both company ratings and country-risk ratings that are not
easily or credibly obtained in another way.28
27. See Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital
Markets: Banks Versus Stock Markets, 47 J. FIN. ECON. 243 (1998); see also Thomas Hellmann &
Manju Puri, The Interaction Between Product Market and Financing Strategy: The Role of Venture
Capital, 13 REV. FIN. STUD. 959 (2000). For evidence on the role of venture capital funds as
reputational intermediaries, see Alon Brav & Paul A. Gompers, Myth or Reality? The Long-Run
Underperformance of Initial Public Offerings: Evidence from Venture and Nonventure Capital-Backed
Companies, 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 capital
markets, see Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the
Credit Rating Agencies, 77 WASH. U. L.Q. 619 (1999).
c. Money manager rating services. For money managers who manage

pension funds and other institutional assets, a cottage industry has arisen of
consulting firms who verify the money managers’ performance claims, and
a related industry that develops performance indexes against which the per-
formance of a money manager with a particular style or investment focus
can be measured.
D. Which Institutions Are Necessary, Which Are Merely Nice to Have?
My long list of core institutions for ensuring good disclosure, and the
additional core institutions for controlling self-dealing discussed in Part II,
raise an obvious question: Which institutions are really necessary, and
which are just extra frosting on an already tasty cake? Underlying that
question is American and British experience, in which strong securities
markets developed together with some of these institutions but predated
others. For example, the United States had active securities markets long
before it had a strong central securities regulator (though the states early
regulated securities offerings). The United States didn’t enforce insider
trading rules (an institution that I consider important for controlling self-
dealing) until the 1960s. In Britain, many stock promoters invested little in
reputation until perhaps the middle of the twentieth century, arguably after
Britain had already developed a strong stock market.29
The interrelationships among institutions—complements in some
respects, substitutes in others—mean that there is no simple answer to this
question. One must evaluate how important each institution is, both by
itself (to the extent feasible) and as part of an overall system. Consider
insider trading. Utpal Bhattacharya and Hazem Daouk report that an
enforced ban on insider trading raises share prices by about 5 percent, other
things equal.30 That suggests that such a ban is important enough to be
considered a core institution, but not absolutely critical. A stock market
can be strong without controls on insider trading; it will be stronger with
these controls.
On the other hand, local enforcement is critical, and therefore honest
courts 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).
804 48 UCLA LAW REVIEW 781 (2001)
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 politicians
to call off the prosecutors or regulators. I can’t prove this, but neither can I
think 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 the

potential for insiders to appropriate most of the value of the company for
themselves—for 50 percent of the voting shares (less if the remainder are
diffusely held) to convey most or all of the company’s value.
Self-dealing can occur in many variants. But a useful division is
between:
(1) direct self-dealing, in which a company engages in transactions,
not on arms-length terms, that enrich the company’s insiders, their
relatives, or friends, or a second company that the insiders control;
and
(2) indirect self-dealing (often called insider trading), in which
insiders use information about the company to trade with less-
informed investors.
Direct self-dealing is a much more important problem than insider
trading. First, it’s far more profitable. Direct self-dealing lets insiders turn
(say) 40 percent ownership of shares into up to 100 percent ownership of
firm value, with little additional investment. Insider trading can’t produce
similar gains. For one thing, insider trading in significant volume requires a
liquid stock market, which countries that don’t control direct self-dealing
won’t have. For another, long-term buy-and-hold investors aren’t directly
harmed by insider trading. You can only be on the losing side of a trade
with an insider if you’re trading.
More critically, if direct self-dealing is hard to control, insider trading
in anonymous securities markets is even harder to control. Without the
institutions that control direct self-dealing, there is little hope of control-
ling insider trading. But the converse isn’t true. A country can control
direct self-dealing fairly well without making the additional investment
needed 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 problem
created by asymmetric information. Investors don’t know which insiders
are honest and which will appropriate most of the company’s value, so they
discount all companies’ share prices. This creates a dilemma for honest
insiders who won’t divert the company’s income stream to themselves.
Discounted share prices mean that a company with honest insiders can’t
receive fair value for its shares. This gives the company an incentive to use
other forms of financing. But discounted prices won’t discourage dishonest
insiders. The prospect of receiving even a discounted price for worthless
paper will be attractive to some insiders.
This adverse selection by issuers, in which high-quality companies
leave the market because they can’t obtain a fair price for their shares while
low-quality companies remain, lowers the average quality of issuers. Inves-
tors rationally react by further discounting share prices. This drives even
more high-quality issuers away from the market and exacerbates adverse
selection. As with asymmetric information, failure to control self-dealing
can result in a death spiral, in which self-dealing and adverse selection
combine to drive almost all honest issuers out of the market and drive share
prices toward zero, save for a few large companies that can develop their
own reputations.
Self-dealing is a harder problem to solve than information asymmetry.
First, honest disclosure of information during a public offering of shares
can’t later be undone. In contrast, after a company sells shares, its insiders
have an incentive to renege on a promise not to self-deal and capture more
of the company’s value than investors expected when they bought the
shares. Again, insurance terminology is helpful—the incentive to renege is
known as moral hazard. This incentive is only imperfectly policed by the
insiders’ concern for reputation to permit future offerings by the company or
future sales by insiders of their own shares.31
Second, false or misleading disclosure in a public offering often occurs
in a formal disclosure document and thus leaves a paper trail. If subsequent
events reveal business problems that the company concealed, the disclosure
deficiencies will often be obvious enough to let investors and regulators
seek damages or other sanctions against the insiders and, if appropriate, the
reputational intermediaries. In contrast, self-dealing is often hidden. It
must be uncovered before it can be policed.
Third, a securities offering is a discrete event that lets investors insist
on participation by reputational intermediaries. Self-dealing lacks a similar
triggering event. The accountants’ annual audit is an important check on
31. For discussion of moral hazard in organizations, see PAUL MILGROM & JOHN ROBERTS,
ECONOMICS, ORGANIZATION AND MANAGEMENT 166–204 (1992).
806 48 UCLA LAW REVIEW 781 (2001)
self-dealing, and securities lawyers can play a role if they prepare the com-
pany’s public disclosure filings, but investment bankers recede into the
background.
Fourth, once a company issues shares at a discount, the insiders may
feel entitled to appropriate most of the company’s value for themselves.
They will resist any change in legal rules that limits this opportunity. An
example can illustrate why insiders can feel this way. Assume that
Company 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 only
50¢ per share for additional shares, both because the investors don’t know
the company’s true value and because they expect insiders to appropriate
most 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, and
a total value of $125.32
If the insiders keep only 50 percent of the company’s value, they have
cheated themselves. Their shares will be worth only $62.50, while the out-
side investors’ shares will be worth $62.50—far more than the outside
investors paid. The insiders’ rational response is to self-deal enough to
capture at least 80 percent of the firm’s value—$100 out of the total value
of $125. They will not feel that they have cheated anyone by doing so, and
will fight legal and institutional reforms that might prevent them from
taking what they see as their fair share of their company’s value.
But in opposing reforms, insiders of already public companies reinforce
a system that won’t prevent them from taking more than 80 percent of the
company’s value if they choose—and some insiders will so choose. If a
national system permits substantial self-dealing, often in hidden forms,
there is no obvious way to ensure that investors get the fraction of any
particular company’s value that they paid for, or even to know what that
fraction is.
B. The Core Institutions that Control Self-Dealing
Just as successful securities markets have developed institutions to

counter information asymmetry, they have developed institutions to
counter self-dealing. My judgmental list of core institutions is presented
below, in an order that makes logical sense, not in order of estimated
importance. 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 single

table.
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 controlling
information asymmetry, because reputational intermediaries play a smaller
role for self-dealing transactions.
(1) A securities regulator (and, for criminal cases, a prosecutor) that: (a) is
honest; and (b) has the staff, skill, and budget to untangle complex self-dealing
transactions.
Insiders often use transactional complexity and multiple intermediaries
to hide their interest in a transaction, and anonymous offshore accounts to
hide insider trading. Proving a self-dealing case often requires developing
a chain of circumstantial evidence that will befuddle ordinary prosecutors,
or at least lead them to seek out easier cases. And insiders often have the
wealth 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 to
prevent asset stripping; and (d) produces decisions without intolerable delay.
As for information asymmetry, honest, sophisticated, and decently paid
judges are basic and often absent, as is the courts’ ability to reach decisions
with reasonable dispatch and to freeze assets before they are moved offshore.
(3) Procedural rules that provide reasonably broad civil discovery, permit
class actions or another means to combine the small claims of many investors, and
accept proof of self-dealing through circumstantial evidence.
As for information asymmetry, meaningful liability risk requires not
just formal liability rules, but also procedural rules that provide reasonably
broad 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 than
for information asymmetry. For misdisclosure in a public offering, there
is usually a written disclosure document that will sometimes be false on its
face. In contrast, for self-dealing, insiders are dealing with themselves, or
(for insider trading) with an anonymous market. They can often avoid
a telltale paper trail. The judicial system must therefore permit wrongdoing
to 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.
808 48 UCLA LAW REVIEW 781 (2001)
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-dealing

transactions.
Insiders won’t voluntarily announce to the world that they are engaged
in 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-dealing
will still take place if the underlying transactions are lawful. Thus, signifi-
cant self-dealing transactions should be subject to review by independent
directors, 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 shareholder
sues ex post, it may be sufficient to vest approval power solely in the inde-
pendent directors. But often, nominally independent directors won’t be very
independent in fact, especially when a company has a controlling share-
holder, at whose pleasure the directors serve. Thus, it can be valuable to give
approval 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 transaction
that 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 over
self-dealing transactions, insiders have a further incentive to hide their share
ownership so they can pretend to be noninterested. Disclosure rules, plus
rules that treat affiliates of insiders as interested shareholders, can prevent
this practice.
More generally, if self-dealing is a significant risk, outside investors
need 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 to
develop 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 smaller
the 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 formal
disclosure obligations. Unlike the situation when a company issues shares
to investors, there is no direct way for investors to insist that reputational
intermediaries review self-dealing transactions. Accountants are the obvious
intermediary that can play this role. Accountant review of self-dealing trans-
actions can emerge by law or by custom. But unless mandated, it will be
opposed 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 disguise
a transaction, or their interest in the transaction, by running one or both
through multiple intermediaries. Thus, accountants must be sophisticated
enough, and auditing standards rigorous enough, to catch at least some of
the subterfuges.
Accountants can’t catch every instance of self-dealing. It would cost
too much for them to investigate every transaction. But this practical limit
only reinforces the need for skilled accountants who know which closets
the insiders are most likely to hide skeletons in, so the accountants can make
good 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 of
self-dealing transactions, so that the accountants will search vigorously and resist
their clients’ entreaties to let them hide or mischaracterize self-dealing transactions.
The reasons for liability risk are the same as for information asymmetry
generally. 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
810 48 UCLA LAW REVIEW 781 (2001)
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 satisfy
the disclosure requirements governing self-dealing transactions.
A disclosure document for a self-dealing transaction, developed to obtain
shareholder approval for the transaction, or annual disclosure that lists self-
dealing transactions during the past year, will commonly be prepared by
securities counsel. An important safeguard of accuracy is counsel’s willingness
to insist on full disclosure, conduct enough due diligence to satisfy themselves
that the disclosure is accurate, and warn insiders about the risks of partial
disclosure.
(12) Law or custom that: (a) requires public companies to have a minimum
number of independent directors; (b) ensures that they approve self-dealing trans-
actions; and (c) imposes on companies and independent directors enough risk of
liability if they approve self-dealing transactions that are grossly unfair to the
company so that the directors will resist the insiders’ pressure to approve these
transactions.
Approval by independent directors is an insufficient safeguard against
self-dealing transactions in countries where the directors’ independence is
in doubt, but this approval is still an important safeguard. The directors’
personal liability if they don’t behave independently is a central support for
this constraint. Company liability can help to persuade the independent
directors to reject transactions that aren’t on arms-length terms. Liability
also offers a powerful argument that the independent directors can use when
insiders propose a dubious transaction.
Independent directors must be given the benefit of the doubt when
they approve a transaction, lest the best directors decline to serve for fear of
financial liability. But if self-dealing is egregious enough, the need for liabil-
ity, to strengthen the directors’ backbones, outweighs the chill on their
willingness to serve. After all, the independent directors can always reject a
transaction, ask an outside expert to approve the terms as fair, or insist on
approval 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, are
important devices to enhance detection of attempted theft (for that is what
self-dealing must be understood as). But they are no substitute for direct rules
against theft and meaningful liability for thieves who are caught. The prin-
cipal civil sanction is liability to shareholders; regulators can also enjoin

future violations or bar offending insiders from being principals of public
companies.
(14) Criminal liability for insiders who intentionally violate the self-dealing
rules.
Return of ill-gotten gains is an insufficient remedy as long as insiders
can hide or spend most of their gains, especially because the probability of
detection is less than one. Damages equal to a multiple of the insider’s gains
are of limited effectiveness given limited insider wealth and the insiders’
ability to hide much of that wealth. Thus, criminal sanctions, enforced by a
specialized 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 tipping
others, as well as on trading yourself. The rules must be enforced, lest insid-
35
ers learn that they can violate the rules with impunity.
(16) A stock exchange with meaningful listing standards, the willingness to
fine or delist companies that violate the self-dealing rules, and the resources to run
a surveillance operation that can catch some insider trading.
For direct self-dealing, stock exchange enforcement, through fines and
delisting (or the threat of delisting), is an important supplement to official
enforcement. For insider trading, the stock exchange is the institution that
is best able to monitor its own trading, looking for unusual patterns that
suggest insider trading. But running a good insider trading surveillance pro-
gram isn’t cheap. The New York Stock Exchange alone will spend $95
million this year on market surveillance, mostly aimed at controlling insider
trading.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 a
measurable effect on share prices, which they estimate at 5 percent, and (3) unenforced rules have
no 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 Exchange
mounts over 100 major insider trading investigations annually and refers 30–40 cases annually for
possible criminal prosecution).
812 48 UCLA LAW REVIEW 781 (2001)
(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 trading
with outsiders. This requires not only general financial disclosure, but also
rules ensuring transparent trading prices.
(18) Rules banning manipulation of trading prices (and enforcement of those
rules).
Public reporting of trades lets insiders manipulate trading prices. “Pump
and dump” schemes, in which insiders of small companies use prearranged
transactions at rising prices to create the appearance of a hot stock, and then
sell 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 can
uncover 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 a
country has a strong financial press that can publicize misdeeds. As for
information asymmetry, overly strong libel laws can chill press reporting.
Reports that uncover self-dealing will often come from securities
analysts rather than the financial press. The more prevalent self-dealing is
in a particular country, the greater the need for analysts to understand how
self-dealing varies from company to company, both to value companies and
to advise clients on which securities to buy.37
(20) A culture of compliance among accountants, lawyers, independent
directors, and company managers that concealing self-dealing transactions, approv-
37. Two Russian examples: First, the Troika Dialog investment bank publishes a weekly
news bulletin, On Corporate Governance Actions, that advises its clients in surprisingly blunt terms
about corporate governance shenanigans by Russian companies. See also JAMES FENKNER & ELENA
KRASNITSKAYA, CORPORATE GOVERNANCE IN RUSSIA: CLEANING UP THE MESS (Troika Dialog,
1999). Second, the Brunswick Warburg investment bank published a numerical ranking of the
corporate 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 listed
on 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 recounted
in Black, Kraakman & Tarassova (2000), supra note 1.
ing a seriously unfair transaction, or trading on inside information is improper and

a recipe for trouble.
In countries with strong securities markets, the sanctions against direct
and indirect self-dealing are strong enough to reinforce a norm against this
conduct. That culture reduces the frequency of self-dealing and improves
the quality of the transactions that occur. Like the related norms support-
ing good disclosure and establishing value maximization as a managerial
goal, the norm and the supporting institutions likely develop together and
reinforce 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 did
in 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’t
propose this, the independent directors wouldn’t approve it, and if it some-
how occurred anyway, the press would report the scandal, and the managers
would face both civil and possible criminal liability. In Russia, the press
reported 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 Russian
company law contains reasonably strong procedural protections against self-
dealing transactions. But Russian companies routinely ignore the rules
because they aren’t enforced. Insiders hide self-dealing transactions, and
(sometimes corrupt) prosecutors and judges usually let the insiders off the
hook in the rare case when a transaction is exposed. Reputational
intermediaries—including major investment banks and accounting firms—
don’t face appreciable liability risk and sometimes choose to look the other
way and accommodate a major client, in ways they would never dream of in
their 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 depends
on 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. (forthcoming
2001), available at http://papers.ssrn.com/paper.taf?abstract_id=241403 (Social Science Research
Network).
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 major
bank loan, syndicated by Goldman, was supported by guarantees from Yukos subsidiaries that were
illegal under Russian company law. Goldman executives later told the New York Times that they
thought Yukos acted legally under Russian law. My personal belief is that, with an eight-digit fee
814 48 UCLA LAW REVIEW 781 (2001)
Incremental steps can help. For example, Italy and Germany have
taken 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 Domestic
Product (GDP). I doubt that this is a coincidence. Italy and Germany could
further strengthen their stock markets if they also enhanced their procedural
protections against self-dealing transactions. But these changes don’t come
easily. The German and Italian disclosure rules were controversial, partly
because they transfer wealth in already public companies from insiders to
outside shareholders.
C. Additional Useful and Specialized Institutions
The list of core institutions in Part B reflects my personal judgment

about which rules and institutions are the most important for controlling self-
dealing. It is not a complete list of the useful rules and institutions. This part
discusses some additional institutions that I consider useful, but not core.
a. One share, one vote. A one-share, one-vote rule that limits the
disparity between voting control and economic rights will reduce insiders’
incentives to self-deal. So will rules that restrict pyramid ownership
structures.41
b. A takeout bid requirement. A mandatory takeout bid rule requires a
new controlling shareholder to offer to buy out all other shareholders at a
per share price comparable to the price that the controlling shareholder
paid to acquire control, unless the minority shareholders waive this right for
a particular transaction. These rights give comfort to outside investors that,
while they must trust the company’s current controlling shareholders, they
have 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 & Timothy
O’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 their
effort 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, SIMEON
D. DJANKOV, JOSEPH P.H. FAN & LARRY H.P. LANG, ON EXPROPRIATION OF MINORITY
SHAREHOLDERS: EVIDENCE FROM EAST ASIA (World Bank, Working Paper No. 2088, 1999),
available at http://papers.ssrn.com/paper.taf?abstract_id=202390 (Social Science Research Net-
work). On the theoretical effects of pyramid structures, see Lucian Bebchuk, Reinier Kraakman
& George Triantis, Stock Pyramids, Cross-Ownership, and Dual Class Equity: The Creation and
Agency Costs of Separating Control from Cash Flow Rights, in CONCENTRATED OWNERSHIP 295
(Randall K. Morck ed., 2000). On their prevalence, see Stijn Claessens, Simeon D. Djankov &
Larry H.P. Lang, The Separation of Ownership and Control in East Asian Corporations, 58 J. FIN.
ECON. 81 (2000).
42. See COFFEE (2001), supra note 19 (abstract) (stressing the need, as a precursor to dis-
persed shareholding, to “protect the public shareholder from stealth acquisitions of control”).
c. Preemptive rights and redemption rights. Especially in a country with

weak overall constraints on self-dealing, company law rules giving minority
shareholders redemption rights (Americans call them appraisal rights) for
mergers and other major transactions, and preemptive rights during public
offerings of shares and convertible securities, can provide useful protection
against some common forms of self-dealing.
d. Public reporting of trades by insiders. Rules that require insiders
to 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 restrict
trading shortly before a major announcement, such as an earnings report.
e. Investment funds and pension funds. Investment funds and funded
private pension plans are indirectly useful institutions. These institutions
are natural investors in publicly traded securities. They don’t directly con-
trol self-dealing, but can provide demand for the market institutions that
constrain 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 core
institution is a bankruptcy system that lets creditors recover most of a com-
pany’s assets after it defaults. For equity markets, a bankruptcy system that
controls asset stripping is useful because it fosters an overall climate that
discourages self-dealing, but I don’t view it as a core institution. Conversely,
some institutions that are important in equity markets, notably those that
control insider trading, are less important for debt markets.
g. A common law judicial system. Common law courts often have a
more flexible decision-making style than civil law courts. That makes them
better able to apply principles of fiduciary duty to sanction subtle forms of
fraud and self-dealing.44 Some developed civil law countries also have
reasonably flexible judging. But many suffer from overly formal judicial appli-
cation of written rules.
43. See Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through
Pretrading Disclosure, 71 S. CAL. L. REV. 303 (1998).
44. See John C. Coffee, Jr., Privatization and Corporate Governance: The Lessons from Securities
Market Failure, 25 J. CORP. L. 1 (1999a); Simon Johnson, Rafael La Porta, Florencio Lopez-de-
Silanes & Andrei Shleifer, Tunnelling, AM. ECON. REV. (Papers and Proceedings), May 2000, at
22; RAFAEL LA PORTA, FLORENCIO LOPEZ-DE-SILANES, ANDREI SHLEIFER & ROBERT
W. VISHNY, INVESTOR PROTECTION: ORIGINS, CONSEQUENCES, REFORMS (Nat’l Bureau of
Econ. Research, Working Paper No. 7428, 2000), available at http://papers.ssrn.com/
paper.taf?abstract_id=227587 (Social Science Research Network).
816 48 UCLA LAW REVIEW 781 (2001)
III. PIGGYBACKING ON OTHER COUNTRIES’ INSTITUTIONS
An important question is to what extent can a company, located in

a country that lacks many of the institutions that control information
asymmetry and self-dealing, rely on other countries’ institutions. A related
question: To what extent can an entire country adapt other countries’
institutions for its own use? This part addresses that question. I use the
term “piggybacking” to refer to this process of using or adapting another
country’s institutions.
Jack Coffee argues that individual companies can often piggyback on
another country’s institutions.45 Some piggybacking is surely feasible, but
I’m more skeptical about its extent. Part A assesses the ease of piggybacking
for 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 securities
markets. It is organized to emphasize the overlap between the institutions
needed 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 a
company or an entire country can piggyback on foreign institutions. I explain
the 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 of
whether piggybacking is feasible, into detailed consideration of which insti-
tutions can be piggybacked (and how effectively), which can’t, and the
obstacles to effective piggybacking. That, in turn, can inform a national
reform 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 the

hardest to transplant. Thus, one can’t transplant local enforcement.
Even if piggybacking is possible, it may not be attempted. Insiders
of already public companies often won’t want their company to provide
additional disclosure of management compensation or self-dealing transac-
tions, or otherwise strengthen controls on self-dealing. They often also
oppose their country’s efforts to piggyback on strong institutions in other
countries.46
Table 1
Estimated Ease of Piggybacking on Foreign Institutions
Needed for: Piggybacking Ease:

Core Institutions Information Self- for a for a
Disclosure Dealing Company Country
Local Enforcement and Culture
1. An honest, sophisticated
securities agency (and prosecu- X X 1 1
tors for criminal cases).
2. Honest, sophisticated, well-
X X 1 1
functioning courts.
3. Good civil discovery rules
and a class action or similar X X 1 2
procedure.
4. A culture of compliance with
disclosure and self-dealing rules
by insiders, reputational interme- X X 2 1
diaries, and independent direc-
tors.
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. (forthcoming
2001) (noting that many Israeli companies that list on NASDAQ have opted for the more relaxed
disclosure (principally of self-dealing transactions) available to foreign issuers under U.S. rules, and
oppose 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, ECONOMICO
E FINANCIERO (J. COMMERCIAL, ECON. & FIN. L.) (forthcoming 2001), available at http://
papers.ssrn.com/paper.taf?abstract_id=247673 (Social Science Research Network) (discussing
Brazilian reform efforts).
818 48 UCLA LAW REVIEW 781 (2001)

Disclosure Rules
5. Rules requiring full disclo-
sure of financial results and self- X X 4 3
dealing transactions.
6. Good accounting and auditing
X X 4 3
rules.
7. Requirements for audited
X X 4 3
financial statements.
8. Ownership disclosure rules. X 4 3
Reputational Intermediaries and Independent Directors
9. A sophisticated accounting
X X 4 2
profession.
10. A sophisticated investment
X 4 2
banking profession.
11. Sophisticated securities law-
X X 4 2
yers.
12. A stock exchange with
meaningful listing standards and
an active insider trading surveil-
X X 5 3
lance operation.
13. Inclusion of independent
X 3 2
directors on company boards.
Liability
14. Civil liability for insiders
who violate the disclosure and X X 2 1
self-dealing rules.
15. Criminal liability for insiders
who intentionally violate the X X 1 1
disclosure and self-dealing rules.
16. Civil liability risk for

X X 3 2
accountants.

17. Civil liability risk for invest-
X 3 2
ment bankers.
18. Civil liability risk for inde-
pendent directors who approve X 2 1
gross self-dealing.
Market Transparency
19. Transparency of trading prices. X X 4 3
20. An enforced ban on market
X X 3 2
manipulation.
Self-Dealing Rules
21. Procedural controls on self-
dealing transactions (review by
independent directors, nonin-
X 4 3
terested shareholders, or both).
22. Accountant review of the
disclosure of self-dealing trans- X 4 2
actions.
23. Enforced securities or other
X 3 2
rules banning insider trading.
Other Institutions
24. An active financial press
X X 3 2
and security analysis profession.
25. A good organization to write
X X 5 3
accounting rules.
Mean ranking: 3.12 2.12
A company’s promise to obey another country’s tougher rules—bonded

by 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 United
States, see Vihang R. Errunza & Darius P. Miller, Market Segmentation and the Cost of Capital in
International Equity Markets, 35 J. FIN. & QUANTITATIVE ANALYSIS 577 (2000); and Darius P.
820 48 UCLA LAW REVIEW 781 (2001)
enhance their own reputations over time, by promising to obey foreign rules
and then keeping that promise. But weak local enforcement and culture
will still lead investors to discount the company’s promises. Moreover, in
many countries, only the largest companies can afford to hire world-class
accountants, bankers, and lawyers.
Consider Vimpelcom—a Russian telephone company that went public
in the United States, is listed on the New York Stock Exchange, has most
of its shareholders in the United States, and has made itself subject to U.S.
accounting requirements and securities laws. That effort helps Vimpelcom’s
shares to trade at a higher multiple of earnings than a comparable Russian
company, traded in the Russian stock market, that follows domestic rules.
But investors still heavily discount Vimpelcom’s shares compared to an
American company with the same prospects because they know that
Vimpelcom’s insiders can cheat and get away with it.
Vimpelcom could potentially bind itself in its charter more tightly
than Russian law requires. But investors won’t fully trust an untested char-
ter provision, especially one that must be enforced in unreliable Russian
courts. For example, another major Russian company, Noyabrskneftegaz,
recently ignored a charter provision that granted preemptive rights to
shareholders, and instead sold shares cheaply to insiders. The resulting
lawsuit by minority shareholders found an unfriendly reception in the
Russian courts and has been abandoned.48 And no charter provision can
stop the Russian government from again—as it recently did—simply taking
core assets from Vimpelcom (in this case, part of the frequency spectrum
that 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. For
example, investors who bought shares of Malaysian companies on the
Singapore stock exchange were unhappily surprised in 1998, when the
Malaysian government declared these shares untradeable. Some Malaysian
companies then proved their own untrustworthiness by offering to buy the
frozen 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 (Institutional
Shareholder 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-five
categories, I assess piggybacking potential for an individual company at 3
or above. The mean ranking is 3.16. Table 2 provides some simple statistics.
Table 2
Company Rankings for Ease of Piggybacking
Ranking Frequency
1 4
2 3
3 5
4 11
5 2
Mean: 3.16
Third, it’s much harder for an entire country, and thus for smaller
firms, to piggyback on foreign institutions than for a single major firm to do
so. For example, a single major firm can adopt international accounting
standards, albeit with some expense and some reduced comparability with
other firms in its home country. However, an entire country’s ability to
adopt complex international rules is limited by the sophistication of local
accountants and by the extent to which local laws are tied to the old
accounting rules, in which case the laws must be changed as well.
Table 3 summarizes the country rankings. No institution receives a 4
or 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 lower
than the mean company ranking of 3.16.
Table 3
Country Rankings for Ease of Piggybacking
Ranking Frequency
1 6
2 11
3 8
4 0
5 0
Mean: 2.12
822 48 UCLA LAW REVIEW 781 (2001)
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 foreign
institutions.
The reasoning underlying these rankings follows. Almost every reader
will likely disagree with me on some of the rankings. I’ve waffled back and
forth 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 criminal

cases (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 civil
discovery rules. A class action or other procedure that lets individual inves-
tors aggregate their claims is important too. In practice, borrowing these
rules has proven much harder in many countries than borrowing substan-
tive shareholder protection rules. This is partly because discovery rules and
class actions implicate the entire civil justice system, and partly because
regulators with jurisdiction over company or securities law often have no
jurisdiction over procedural rules.51
This is the only institution for which the country ranking exceeds the
company ranking. A country can try to adapt foreign discovery and class
action 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 to
import 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 had
been recently rejected by the legislature, and reraising the issue was deemed not to be politically
viable.
hire foreigners to sit on its board of directors and to work in its financial
department. That helps, but only so much. The bulk of the staff will be
local and can hide local skeletons from the foreigners. And the locals’
thought processes, as they consider engaging in self-dealing or disclosing
something 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 York
Stock Exchange or NASDAQ (say) and subject itself to U.S. disclosure and
accounting rules. The company still may not follow the disclosure rules as
attentively as an American company, nor as honestly if the company gets
into financial trouble and the insiders face a final period problem. Hence
the company ranking of 4 instead of 5.
It’s much harder for a whole country to borrow disclosure rules. For
example, American securities laws can’t be simply copied and transplanted
wholesale to another country. They won’t mesh with other local institu-
tions, will likely conflict with other local laws, will be far more complex
than needed, and will in some respects be weaker than needed, because offi-
cial rules can be less strict when informal enforcement is strong. Effective
borrowing of disclosure rules from abroad requires close collaboration
between 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, the
transplantability of a whole body of law warrants a 3 ranking at best.
(6) Good accounting and auditing rules (company ranking = 4, country
ranking = 3).
(7) Requirements for audited financial statements (company ranking = 4,
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. The
founders of the chaebol (Korean conglomerates) are wealthy but not unseemly so; related party
transactions within a corporate group are more often intended to prop up losing companies than
to 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 past
history is so bad.
824 48 UCLA LAW REVIEW 781 (2001)
Audit requirements and accounting rules are not too hard for a com-
pany to borrow from abroad. The rules exist in reasonably clear form—the
most common choices are U.S. General Accepted Accounting Principles or
International Accounting Standards. At some extra cost, a company can
keep two sets of accounts, one following local rules and the second follow-
ing international rules, and can hire an international accounting firm to
audit its financial statements. Weak local enforcement will still limit the
credibility of the financial statements. Extra cost, lack of local enforcement,
and reduced comparability with other domestic companies explain why
these institutions receive a 4 rather than a 5 ranking.
Transplanting accounting rules and audit requirements is harder for a
country than for a single company. A country can adopt foreign accounting
rules and audit requirements, but local accountants must implement these
rules. 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. A
single company can list on a foreign stock exchange and subject itself to the
exchange’s disclosure rules. The company and its insiders still may not follow
the rules as attentively as they might if there were serious sanctions for
misdisclosure. Hence the company ranking of 4.
A country’s ownership disclosure rules must fit into its overall legal
framework. For example, if courts don’t see immediately that if Company
A controls Company B, which controls Company C, then Company A also
controls Company C, then disclosure rules that work fine in a developed
country 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, country

ranking = 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 C
a subsidiary of Company A. This affects, among other things, whether a transaction between C and
A is governed by the rules that require noninterested shareholders to approve related-party transactions.
(11) Sophisticated securities lawyers (company ranking = 4, country

ranking = 2).
A major company can hire international accountants, investment
bankers, and lawyers. This isn’t cheap, but can produce reasonably effective
reputational intermediation. Investors will have less confidence in the inter-
mediaries’ recommendations than in a country with good local enforcement
and 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 them
to enter, compete with local firms, and hire local people, some of whom will
later join or start local firms. But building a sophisticated local profession is a
decades-long task. Doing so requires strong university-level education, and
also requires a capital market to develop that creates the demand for these
professionals 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 active
insider trading surveillance operation (company ranking = 5, country ranking
= 3).
An individual company can list its shares on a foreign exchange and
obtain most of the reputational benefits from doing so. Hence the rare
company ranking of 5. A caveat: Some stock exchanges try to attract for-
eign listings by offering reduced listing standards. The New York Stock
Exchange, for example, has long wanted to accept less financial disclosure
than the United States Securities and Exchange Commission is willing to
accept. 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 rules
and 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 and
expect local firms to list abroad, perhaps on a regional exchange. These
options make stock exchanges easier to borrow than other reputational
intermediaries, 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 new
tough 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 Neuer
Markt’s rules, see Vanessa Fuhrmans, Playing by the Rules: How the Neuer Markt Gets Respect,
WALL ST. J., Aug. 23, 2000, at C1.
826 48 UCLA LAW REVIEW 781 (2001)
(13) Inclusion of independent directors on company boards (company

ranking = 4, country ranking = 2).
A single company can appoint truly independent directors, including
foreign directors. But local directors’ actions will still depend partly on
local culture and on the behavior of other directors in the same country.
Foreign directors bring their culture with them, but may be hard to recruit
because of language barriers and geographic distance, and will be less
informed 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 of
independent directors as a way to promote independent director review of
self-dealing transactions, but it can’t do much to make the directors truly
independent. Hence the lower country ranking of 2.
Liability
(14) Civil liability for insiders who violate the disclosure and self-dealing
rules (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 can
be delisted from a foreign exchange if it misbehaves. But these exposures
are 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 from
locals 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 be
imported wholesale. Moreover, good rules aren’t worth much without local
enforcement.
(15) Criminal liability for insiders who intentionally violate the disclosure
and self-dealing rules (company ranking =1, country ranking = 1).
Most countries impose criminal sanctions on corporate crooks, but
enforcing these sanctions requires local discovery, local courts, and local
prosecutors. These can’t be imported. Moreover, criminal rules must fit
within an existing legal framework. They can’t be imported wholesale, the
way 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, country

ranking = 2).
(17) Civil liability risk for investment bankers (company ranking = 3,
A company can offer shares overseas, subject to overseas rules, using
international accountants and investment bankers. It will thereby subject
the accountants and bankers to foreign as well as local liability. But proof
problems can be severe. Intermediaries are typically liable only if their
conduct is culpable—whether the degree of culpability is negligence, gross
negligence, recklessness, or something else. Proving culpability requires
local facts, which are often hard to uncover. Thus, in practice, weak local
enforcement greatly reduces the liability faced by reputational intermediar-
ies. Hence the company ranking of 3.
A country that wants to create liability for reputational intermediaries
will often need to change not only its substantive rules, but its procedural
rules as well, so that small investors can aggregate their claims. And local
enforcement is still hostage to the strength of local courts. Moreover, the
intermediaries will oppose strong local liability rules. Internationally
known intermediaries will fear that liability judgments may reflect home-
court bias, corruption, or a desire to compensate local investors at the
expense of deep-pocketed foreigners. Those worries can only be assuaged
by strong local courts and experience over time. Until then, strong liability
rules may scare away world-class intermediaries, instead of prompting them
to 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 assets
locally. In practice, they will be liable (if at all) only under local law. That
brings 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 company
can create some foreign liability for itself by listing its shares on a foreign
exchange, and the company’s liability indirectly affects the directors.
Market Transparency
(19) Transparency of trading prices (company ranking = 4, country

ranking = 3).
A company can ensure transparency of trading prices by listing on a
foreign exchange in a country with strong transparency rules and hiring a
good registrar, which can refuse to register share transfers that don’t comply
828 48 UCLA LAW REVIEW 781 (2001)
with the transparency rules. But many countries restrict foreign ownership
of shares, restrict listing on a foreign exchange, or insist that major com-
panies also list on a domestic exchange with weaker transparency. Hence
the 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 my
experience, efforts to achieve these goals often meet various technical diffi-
culties. Also, company insiders and local investment bankers, who benefit
from nontransparency, often oppose the rules and impede the process of
implementing them. Moreover, a country needs to be able to enforce the
transparency rules against the exchange and the registrars. On balance, a
country ranking of 3 seems warranted.
(20) An enforced ban on market manipulation (company ranking = 3,
An effectively enforced ban on manipulating market prices is an
important accompaniment to market transparency rules. Making such a
ban effective requires local enforcement, because whether trading is benign
or 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 by
the company’s internal culture of compliance and by maintaining a good
record 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 the
overall disclosure environment is weak, managers may hide transactions or
appoint compliant independent directors to approve them. If the court sys-
tem is weak, shareholder lawsuits may fail even if the procedures aren’t
followed. The country ranking of 3 combines the feasibility of importing
these 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, the
extent to which insiders will take these steps depends on managerial culture
and 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 of
transaction disclosure to control self-dealing. But the procedures can still catch
only a fraction of the self-dealing that insiders engage in, especially if the
local accounting profession is weak. And the incentive to self-deal will be
strong 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 the
sophistication of its accountants and general cultural acceptance of self-dealing.
(23) Enforced securities or other rules banning insider trading (company
Insider trading can be banned as a formal matter, but policing insider
trading is difficult everywhere, and nearly impossible if local institutions are
weak. Much of the proof (A is related to B, who knows C, who actually
traded) will be local, and thus hard to come by. It helps a bit if a particular
company 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 produce
a company ranking of 3 and a country ranking of 2.
Other Institutions
(24) An active financial press and securities analysis profession (company

The financial press must be mostly homegrown. It can’t be tailored to
a particular company’s needs. Critical coverage can be chilled by overly broad
local libel rules or, in some countries, cruder threats and sometimes actions
against offending journalists. At the same time, a country can improve finan-
cial reporting by welcoming the international financial press (the Wall Street
Journal, Financial Times, Economist, and the like). These journals can provide
some reporting themselves, and their example can also raise local profes-
sional standards. A country can also encourage foreign investment banks to
establish local offices; the banks will then hire local analysts.
Large companies can encourage coverage by the press and securities
analysts, hence the higher ranking (3 instead of 2) for a company than for an
entire country.
(25) A good accounting rule-writing organization (company ranking = 5,
Building a domestic rule-writing organization is hard, but companies and
countries that adopt a foreign set of accounting standards can largely piggyback
on the organization that writes these rules and keeps them updated. That
830 48 UCLA LAW REVIEW 781 (2001)
warrants a company ranking of 5. The possible need for specialized local rules,
and for integrating the rules with other domestic laws, explains the lower
country ranking.
B. Can Substitute Institutions Facilitate Piggybacking?
Some readers of this Article have commented that they can imagine
new institutions that could partially substitute for weak local regulation. For
example, 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 court
judgment. Purchasing a directors’ and officers’ insurance policy can have a
similar effect.
Creative efforts to limit domestic risk can be important. For example,
companies in countries with significant political risk sometimes go to great
lengths to issue securitized debt that reduces this risk.56 This suggests that
similar efforts could reduce the share price discounts that result from weak
local regulation.
And yet, such substitutes mostly haven’t developed. One possible
explanation is that no one has seriously tried. The substitutes are a finan-
cial innovation yet to be born. A competing explanation is that the gains
from innovation are smaller than the associated transaction costs. The first
mover in adopting a new institution bears much higher transaction costs
than later adopters. The first mover will also suffer from information
asymmetry because investors won’t understand the innovation and will be
skeptical about whether it will work as promised. We can’t easily distin-
guish between these two explanations. But I suspect that if the gains were
large and capturable at modest cost, we’d see some efforts to capture them.
Consider the escrow account strategy. First, the escrow amount must
be only a fraction of the capital the company plans to raise, or else the
company won’t raise any net investable capital. But a fractional escrow is
only fractionally effective in discouraging self-dealing. Second, an escrow
will 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 are
placed in escrow, the company faces flotation costs of 17 percent of the
investable amount raised.57 Third, tax rules may raise the cost of placing
funds 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 and
thereby collect on the escrow. Finally, the escrow strategy requires complex
contracting over the conditions to be satisfied before the escrow can be
released.
Consider next the charter amendment strategy: Companies can limit
self-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 going
public for the first time have incentives to adopt these limits to get a better
sale 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 high
self-dealing risk, thus undercutting the provision’s value; (3) the malleabil-
ity of corporate form may let the insiders escape coverage, if they later
decide to; and (4) investor attention will be diverted from understanding
the prospects of the business to understanding the fine details of a charter
provision.
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, offer
alternatives. If these alternatives work well, whether a country has a strong
securities market won’t greatly affect its economic prospects. This part
assesses what we know about whether (and how much) a country should
care about developing a strong securities market.
At a qualitative level, there is reason to believe that securities markets
have some advantages over their principal competitors as a means to raise
capital (Part A). In addition, a recent body of empirical evidence supports
the 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 linking
investor protection and the strength of securities markets to economic
growth (Part C).
The economic importance of strong securities markets should not
be overstated. Some advanced economies have these markets; others have
developed 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 similar
results (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).
832 48 UCLA LAW REVIEW 781 (2001)
institutions that support strong securities markets are needed if a country is

to have strong capital markets of any sort.
A. The Qualitative Case for Strong Securities Markets
Securities markets have a number of potential advantages over bank

financing 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 are
prone to credit crunches and other troubles that can reverberate through
the whole economy. Even in advanced bank-centered countries, usually with
decent 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 and
resulting bailouts and recessions. Banks are also a cash business, hence easy
to loot, especially in countries with weak investor protections. And short-
term financing can increase the severity of economic crises, as investors refuse
to re-lend when the need for capital is greatest.59
Second, when external equity markets are weak, family-controlled
conglomerates create internal capital markets instead. Especially in eco-
nomic downturns, these conglomerates often send good money after bad in
an effort to prop up money-losing subsidiaries. And many conglomerates
that do well when run by a first-generation entrepreneur run into trouble
once the heirs take control.60
It’s striking, and likely not coincidental, that the East Asian countries
that best survived the 1997–1998 Asian financial crisis either had relatively
strong stock markets (Taiwan, Hong Kong, and Singapore) or a mostly closed
economy (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 AN
ECONOMY—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 & Luigi
Zingales, 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 record
of second-generation family members in running family firms, see Randall K. Morck, David A.
Stangeland & Bernard Yeung, Inherited Wealth, Corporate Control and Economic Growth: The
Canadian 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 arise
in a country with weak legal protections against self-dealing. Controlling
shareholders’ incentives to self-deal are tempered in good economic times
by concern for reputation. When the economy turns sharply down, many
firms face possible insolvency. Their owners are now in a final period, in
which reputational constraints are weak, and scramble for the exits. Insider
looting exacerbates stock market decline; the stock market decline reduces
firms’ prospects and encourages looting, and the looting exacerbates the
economic downturn.
Third, a stock market lets companies rely more on external capital and
less on internal capital. This helps firms grow rapidly and gives companies
that focus on a single core business an advantage over diffuse conglomer-
ates. In the United States, conglomerates are usually less efficient than
more focused firms.62 Conglomerates remain strong in countries with weak
stock markets, partly because the conglomerate form can provide the capital
that a rapidly growing business needs.
Fourth, a strong equity market permits venture capital and leveraged
buyout promoters to exit from their investments through an initial public
offering. The availability of this public market exit may be an important
precursor to a vibrant venture capital industry.63
Fifth, foreign capital inflows can support domestic growth. Securities
markets allow the inflow channel of portfolio investment, and thus can
increase total capital inflows.
Finally, the same institutions that strengthen stock markets also often
strengthen the banking system. Honest courts and prosecutors and a strong
accounting profession are needed whatever the nature of a country’s capital
market. So too for the government capacity to regulate core capital market
players, whether they be commercial banks or investment banks. And the
lower cost of capital provided by a strong stock market will benefit banks
when they raise their own equity capital, permitting the banks to lend more
cheaply. In many countries, banks are among the leading publicly traded
companies, 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.
834 48 UCLA LAW REVIEW 781 (2001)
Looking narrowly at developed countries, stock markets and banks can

look like substitute sources of capital. But across a broad range of countries
in different stages of development, strong banking systems are usually found
together with strong stock markets. For example, Ross Levine and Sara
Zervos report a strong 0.65 correlation between bank loans to private sector
borrowers and stock market capitalization, both measured as a percentage of
GDP.64
B. Empirical Evidence: Investor Protection and Strong Capital Markets
Research on the empirical correlation between investor protection and

the strength of a country’s securities markets or its economy is in its infancy.
Early results suggest that both correlations exist; further research is needed
to tease out the relationship between them. Issues of multicollinearity and
unclear causation abound. A threshold issue is the proxy that one uses for
securities market strength. The most common proxies are stock market capi-
talization as a percentage of GDP and liquidity (average bid-asked spread as
a 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 larger
stock market capitalization as a percentage of GDP, higher valuation of
minority shares (measured by Tobin’s q), less concentrated share ownership,
more public companies relative to population, and higher dividend payout
rates.65
The premium price accorded to high-voting shares, for companies that
have two classes of tradable shares, offers a rough measure of the level of
private benefits that outside investors expect insiders (who mostly hold
high-voting shares) to extract. Franco Modigliani and Enrico Perotti
document an inverse relationship between the premium on high-vote
shares 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 the
World, 54 J. FIN. 471 (1999); FLORENCIO LOPEZ-DE-SILANES, ANDREI SHLEIFER & ROBERT
VISHNY, 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, Andrei
Shleifer & 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 between
67
the premium on high-vote shares and legal protection for minority investors.
Ross Levine confirms the LLSV correlation between investor rights and
stock market capitalization for a different sample of countries, and finds a
separate correlation between the quality of accounting disclosure and stock
market capitalization. The latter correlation supports the view, expressed
above, that strong accounting rules are a core market-supporting institution.68
The evidence on the correlation between legal protection and the
strength of banks is consistent with the evidence on securities markets. For
example, Ross Levine finds that measures of creditor rights and of general
contract 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, ought

to 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 many
factors that affect investor protection, on the one hand, and investment
and growth, on the other, teasing this predicted relationship out of the data
will be hard, even if the relationship in fact exists. The most that can be
said at this point is that the correlations between strong investor protection
and 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 “rule
of 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/
68. See Ross Levine, Napoleon, Bourses, and Growth: With a Focus on Latin America, in
MARKET AUGMENTING GOVERNMENT (Omar Azfar & Charles Cadwell eds., forthcoming 2001).
69. See Ross Levine, Law, Finance, and Economic Growth, 8 J. FIN. INTERMEDIATION
8 (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) (finding
a correlation between a measure of creditor rights and bank assets as a percentage of gross domes-
tic product).
836 48 UCLA LAW REVIEW 781 (2001)
inversely with GDP. In an endogenous variables (two-stage least squares)

analysis, the direction of causation appears to run from better governance to
higher per capita GDP.70 Robert Hall and Charles Jones report similar results
71
for a single broad measure of social infrastructure. These broad governance
measures 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 strong
institutions achieve stronger growth.
Peter Henry finds a related correlation: Countries that open their
stock markets to foreign portfolio investment experience higher stock prices
and a resulting increase in physical investment. Henry attributes the higher
stock prices to greater diversification by foreign investors, which makes
them willing to accept lower expected returns than domestic investors. A
second 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 by
liquidity) and commercial bank strength (measured by loans to private bor-
rowers as a percentage of GDP) separately predict economic growth. This
suggests that strong stock markets and strong commercial banks are separate
precursors of growth—more complements than substitutes. Stock market
size (relative to GDP) also predicts economic growth, but less robustly than
liquidity. The observed correlations survive when the authors add a control
variable for legal efficiency. This suggests that capital market development
has a positive impact on growth, apart from its institutional precursors.73
Jeffrey Wurgler reports one reason why stock market strength may predict
faster 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 economic
growth); Levine & Zervos (1998), supra note 64; P.L. Rousseau & P. Wachtel, Equity Markets and
Growth: 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 and
current growth or investment). For theoretical models linking stock market liquidity to lower cost
of 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 predicts

improved capital allocation.74
A separate line of research finds a correlation between banking sector
strength and economic growth.75 This raises the possibility that banks are the
real growth engine, and strong stock markets merely happen to be cor-
related with strong banks. The Levine and Zervos results suggest that banks
and stock markets have separate growth-promoting effects.
Raghuram Rajan and Luigi Zingales argue that greater financial sector
activity might merely anticipate, rather than cause, future economic
growth. They respond to this concern by reporting evidence that a com-
bined measure of banking sector and stock market size predicts faster growth
differentially in industries that rely on external financing.76 Ross Levine
and 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 predicts
stronger banks, and the portion of banking development attributable to
stronger creditor protection predicts future economic growth; and (2) legal
protection of shareholder rights and strong accounting rules predict strong
stock markets, and the portion of stock market development attributable to
shareholder rights and accounting disclosure predicts future economic growth.77
Asli Demirguc-Kunt and Vojislav Maksimovic study firm-level rather
than economywide growth. They report that firms in countries with stronger
legal systems and more active stock markets, measured by annual turnover
ratio, rely more on long-term external financing (both equity and long-term
debt) to finance growth, and earn lower returns on invested capital. This is
consistent with a lower cost of capital and with greater competition, fos-
tered by greater access to capital. Like Levine and Zervos, they find stronger
results for a measure of stock market liquidity than for stock market size (as
a percentage of GDP). A variable for an effective legal system predicts
faster 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 and
Agenda, 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, Norman
Loayza & Thorsten Beck, Financial Intermediation and Growth: Causality and Causes, 46 J. MONE-
TARY ECON. 31 (2000).
838 48 UCLA LAW REVIEW 781 (2001)
are significant and the legal effectiveness variable is not, suggesting that the
value 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 stock
markets, rather than public debt markets, another paper by Demirguc-Kunt
and 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: A

SEPARATING EQUILIBRIUM?
The interdependence of many of the institutions that control informa-

tion asymmetry and self-dealing creates the potential for two separating
equilibria to exist. In the first, lemons equilibrium, many institutions that
support a strong securities market are weak or absent. Honest companies
(except a few large companies that develop their own reputations) rarely
issue shares to the public, because weak investor protection prevents them
from realizing a fair price for their shares. This decreases the average quality
of the shares that are issued, which further depresses prices and discourages
honest 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 protection
produces prices that induce honest companies to issue shares, which increases
the average quality of the shares that are issued, which further increases
share prices and encourages more honest issuers to issue shares. But, higher
share 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 and
self-dealing.
Moreover, many institutions that support a strong securities market are
endogenous 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 and
Investment 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), available
at 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 develop
strong 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 produces
demand for a security analysis profession. The investment fund industry is
large and politically influential because it has a large, deep securities market
that 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 countries
will develop other ways to finance businesses. Bank financing is an obvious
alternative. But bank-dominated financing produces strong banks, both
financially and politically. The banks will resist legal changes that might
strengthen 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 then
fight against rules and institutions that limit self-dealing.
Conversely, a country with a strong securities market is more likely to
strengthen and enforce the rules that maintain that market. In the United
States, the Securities and Exchange Commission is a strong regulator partly
because 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 pressure
from public company managers for weaker rules. The Financial Accounting
Standards Board writes relatively strong accounting rules partly because
institutional 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 coauthors
report that common law countries have a better match between accounting
and economic income than civil law countries.82 And Laura Beny finds that
countries 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 VERSUS
STANDARDS: PROPERTIES OF ACCOUNTING INCOME IN FOUR EAST ASIAN COUNTRIES, AND
IMPLICATIONS FOR ACCEPTANCE OF IAS (working paper, 2000), available at http://papers.
ssrn.com/paper.taf?abstract_id=216429 (Social Science Research Network).
840 48 UCLA LAW REVIEW 781 (2001)
and less liquid securities markets, than countries with more dispersed share
ownership.83
A country with a strong securities market is more likely to build a
venture capital industry, which depends in important part on the possibility
84
of exit from portfolio investments through an initial public offering. The
venture capital industry then generates a regular supply of initial public
offerings, which strengthen demand for the other institutions that support
these public offerings.
The cultural preconditions for strong or weak securities markets can
also 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 from
the norm, and there is political support for the funding to maintain the
enforcement that reinforces the cultural norm. In a weak market, weak
disclosure and extensive self-dealing become self-reinforcing norms. Many
businesspeople behave this way, many of them get away with self-dealing
because regulators (even if honest and decently funded) can address only
the most egregious cases, and the self-dealers oppose stronger rules or better-
funded regulators.
Corruption, a critical obstacle to strong securities markets, is also likely
to be endogenous. In weak markets, honest, decently funded judges, regula-
tors, and prosecutors are less likely to emerge, because they threaten the
politically powerful controllers of large enterprises. The wealth of enter-
prise controllers in turn provides the capital needed to sustain the status
quo of corruption and weak enforcement. Also, once corruption becomes
entrenched, dishonest people will (and honest people won’t) seek to work
as regulators. And no one resists anticorruption reforms more strongly than
already 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 the
resources they are given to do so. A corrupt government isn’t likely to write
strong rules against self-dealing or fund strong enforcement efforts. Com-
panies will offer inducements to legislators to include loopholes in the rules
and 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, in
which the core endogenous institutions have been built and enjoy political
support, and a lemons equilibrium in which many of these institutions are
absent and building them faces strong political opposition.85
I intend the concept of a separating equilibrium to be a qualitative
one. Incremental improvements in a country’s securities market are possi-
ble. Even in the weak markets equilibrium, some companies can develop
strong reputations and obtain respectable prices when they sell shares to
outside investors. The better a country’s institutions, the more companies
will be able to sell shares, relying partly on their own and partly on the
country’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 and
politically.
Nonetheless, the concept of separating equilibria can capture the diffi-
culty a country is likely to face in moving from a bank-centered capital
market, in which mature companies go public largely based on their own
reputations, to a stock-market-centered capital market in which new com-
panies have access to public capital because they can trade on the built-up
reputations of others, especially reputational intermediaries, and on factors
like culture and enforcement that make fraud or self-dealing less likely
among companies that haven’t yet built their own reputations. Parts I and
II of this Article can be seen as an attempt to develop minimum conditions
for a country to achieve the strong markets equilibrium.
VI. IMPLICATIONS
A. Different Types of Monitoring: Investor Protection

and Firm Performance
A major theme in comparative research on corporate governance over

the 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 a
country’s capital markets. He argues that Western European social democracies are politically
hostile to the emphasis on shareholder profits that characterizes countries with strong securities
markets, 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 transfer
wealth to other stakeholders. His analysis is limited to rich countries, which wouldn’t be rich
unless 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.
842 48 UCLA LAW REVIEW 781 (2001)
of bank-centered and stock-market-centered capital markets. The standard

debate posits that bank-centered capital markets, such as Germany and
Japan, offer greater ability of banks to monitor managers and ensure that
the company is well managed. That company insiders won’t simply collude
with the bankers to steal from the company through self-dealing
transactions is taken for granted or treated as a minor concern.86
The standard analysis recognizes that stock-market-centered capital
markets 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 greater
capital-raising opportunities for companies with intangible assets, against
which banks can’t easily lend. They can develop an active market for
corporate control, that can indirectly monitor performance and partly sub-
stitute for weaker direct shareholder oversight. Still the debate assumes
that bank-centered capital markets can produce stronger monitoring than
stock-market-centered systems. The analysis developed above suggests that
this assumption may be misplaced.
Monitoring has two basic dimensions—monitoring insiders, to ensure
that they don’t steal the company’s value from investors (shareholders or
creditors), and monitoring management performance, to ensure that a com-
pany maximizes that value. I argue above that a country can develop strong
securities markets only if it succeeds along the first dimension. This sug-
gests that countries with stock-market-centered systems are likely to have
stronger protections against self-dealing than countries with bank-centered
systems. Bank-centered systems may even develop partly because a country
controls self-dealing too poorly to permit a stock-market-centered capital
market to flourish.87
It’s also unclear which type of capital market is better at monitoring
managers to ensure that they maximize firm value. This form of monitoring
requires information about manager performance, skill to interpret that
information, and power to act if performance is weak. Stock-market-
centered capital markets can provide better information about performance
than bank-centered capital markets. Also, equity investors may have
stronger 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 Institutions
Matter?, 74 WASH. U. L.Q. 327 (1996).
87. For a related suggestion that large shareholders emerge when other means of controlling
shareholder-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 aversion
that is embedded in bank lending practices.
Even if dispersed shareholders as monitors have information, they have
limited power or incentive to act on that information. But some constraints
still exist. A low stock price, complaints from unhappy shareholders, and
negative reports from analysts or the financial press all send signals to the
board of directors about management’s performance, which some boards
will 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. The
combination of better disclosure, less risk-averse and perhaps more skilled
monitors, albeit with less direct ability to act on adverse disclosure, may
plausibly 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 cost
in weaker monitoring, once we define monitoring broadly to include both
controls against weak management (on which most corporate governance
scholarship focuses) and controls against self-dealing (which loom large in
many countries).
B. Competition Between Securities Regulators
Should firms be able to choose their securities regulator? This would

open up regulatory competition, akin to American competition between
states for corporate charters. Partial competition exists already, through
firms’ choices of where to list and issue their shares. But competition advo-
cates would go further. Roberta Romano argues that letting American states
compete to offer securities regulation could produce more cost-effective
disclosure rules; Stephen Choi and Andrew Guzman propose competition
among national securities regulators.88 Merritt Fox responds by proposing
national regulation of home-country issuers, regardless of where they issue
securities; Uri Geiger prefers disclosure rules established by an international
superregulator.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, Empowering
Investors: 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 Regulate
Whom, 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); Merritt
B. 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 Disclosure
Rules in the Global Market, 1997 COLUM. BUS. L. REV. 243 (1997); Uri Geiger, Harmonization of
844 48 UCLA LAW REVIEW 781 (2001)
My analysis suggests that this debate is misguided. It focuses primarily

on disclosure rules, when the real competition is between national systems
for fostering strong disclosure and controlling self-dealing. Disclosure rules
are a small part of the network of institutions that support strong disclosure;
the securities regulator’s role in adopting disclosure rules is not critical
to having good rules; and this role is a small part of the regulator’s overall
job. The core regulatory role is enforcing standards of conduct against
issuers and reputational intermediaries who flagrantly violate the disclosure
rules, not tweaking those rules at the margin.
Moreover, even on the narrow terrain of disclosure rules, competition
is unlikely to achieve the intended goal of producing more cost-effective
rules. Companies can already prepare disclosure to a higher foreign stan-
dard if they like. Regulatory competition lets companies that face strict
local standards choose more relaxed standards instead. Companies have
two 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 detailed
accounting 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 permits
hidden reserves, will suffer a double hit to its share price. It will lose the
benefit of comparability with similar U.S. companies, and investors will
assume that it has something to hide. This is the same adverse selection
effect I described earlier in this Article, in a different guise.
Investors know that, on average, companies that choose less stringent
disclosure want to hide something—perhaps bad results, management com-
pensation, or self-dealing transactions. They will discount the company’s
share price for that risk, despite the company’s predictable claim that it just
wants to reduce its accounting costs. This will make switching costly and
lead many potential switchers that want to reduce accounting costs not to
switch. But companies with something to hide will still switch as long as
what 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 that
investors will apply to the switchers. That further discourages companies
Securities Disclosure Rules in the Global Market—a Proposal, 66 FORDHAM L. REV. 1785 (1998); see
also Howell Jackson & Eric Pan, Regulatory Competition in International Securities Markets: Evidence
from Europe in 1999, 3 THEORETICAL INQUIRIES L. (forthcoming 2001) (reporting that disclosure in
European offerings by major European issuers exceeds most European requirements and
approaches U.S. levels, implying little change in disclosure practices if regulatory competition
were permitted).
from switching to reduce accounting costs, increases the percentage of loss-

hiding switchers, and increases the expected amount of bad news they are
hiding. The adverse selection effect on price is compounded because the
fewer 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 costs
of switching will swamp the modest accounting cost savings. If so, competi-
tion among regulators to issue disclosure rules will permit some companies
to hide bad news and won’t produce much pressure on rule writers to pro-
vide cost-effective rules. Moreover, the competing regulators know that
managers make the switching decision, not shareholders. They often do so
without the constraining influence of the need to obtain shareholder
approval. 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. The
United States permits foreign companies to provide more limited disclosure
than 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 convergence

between different corporate governance systems. The polar positions in this
debate can be represented by (1) the argument by Henry Hansmann and
Reinier Kraakman that convergence at the level of formal legal rules is
already largely complete;91 and (2) the argument by Lucian Bebchuk and
Mark Roe that political forces and path dependence will limit the extent
92
of convergence. Ron Gilson takes an important intermediate position,
emphasizing that different formal rules can produce similar outcomes, which
he 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 Science
Research Network).
92. See Lucian Arye Bebchuk & Mark J. Roe, A Theory of Path Dependence in Corporate
Ownership and Governance, 52 STAN. L. REV. 127 (1999); see also Douglas M. Branson, The Very
Uncertain 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 Science
Research Network).
93. Gilson (2001), supra note 58.
846 48 UCLA LAW REVIEW 781 (2001)
with respect to the level of generality at which outcomes are expected to

converge.94
This Article argues that a fair amount of functional convergence must
underlie strong securities markets. To create these markets, countries must
solve a limited number of core problems, including the information asym-
metry and self-dealing problems that I stress. My analysis also suggests that
much of whatever convergence takes place (a topic on which I express no
opinion here), will be functional (at a rather high level of generality) rather
than formal. Formal legal rules play an important but limited role in a
country’s overall corporate governance system.95 Enforcement institutions
are also critical. And enforcement institutions diverge widely, are hard to
change quickly, and are not susceptible to formal convergence in the way
that legal rules are.
Moreover, the institutions that support securities markets and thus, in
important 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 enforcement
institution. Consider first a takeout bid requirement when control changes
hands, which is useful for controlling self-dealing. One important element
of convergence is surely the rights of minority shareholders in control trans-
actions. But now consider some of the possibilities among countries that
acceptably 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 AND
TENDENCIES 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 Global
Cross 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 the
Road 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 Substantive
Rules and Convergence of Enforcement: Correlation and Tradeoffs, in ARE CORPORATE GOVER-
NANCE SYSTEMS CONVERGING?, supra note 91; Amir N. Licht, International Diversity in Securities
Regulation: Some Roadblocks on the Way to Convergence, 20 CARDOZO L. REV. 227 (1998); JEFFREY
MACINTOSH, 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, Property
Rights 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’Y
INT’L BUS. 1 (1997); and Heidi Mandanis Schooner & Michael Taylor, Convergence and
Competition: 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 by

majority vote, requiring equal prices for controlling and noncontrolling
shares, or adjusting the price for general market movements or the time
value of money. Or, as the United States has, it can have no takeout bid
rule, but substitute a norm of buying all outstanding shares at the same price
during a change of control, policed by strong independent directors who
refuse to accept any other proposal—even though they can lawfully do so
under Delaware case law.96 These possibilities converge functionally at the
level of generality of protecting minority shareholders against self-dealing
by a new controlling shareholder, but in different ways, with different
degrees of protection.
But a country can sustain a strong securities market with no takeout
bid rule or practice, if it otherwise strongly protects minority shareholders
against self-dealing, so that the self-dealing risk from a control change
is small. This arguably describes American practice until about 1985.
Countries with and without takeout bid rules will then have converged
functionally 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, myself
among them, consider useful in controlling self-dealing—a common law
legal system. We can hope that this institution is not critically important
for this task. Otherwise, most of the world can’t build strong securities mar-
kets, because this institution isn’t transplantable. If strong markets emerge
in civil law countries, as recent signs suggest is happening, these countries
will converge functionally with common law countries at the level of gen-
erality of an overall set of institutions that protects minority investors
against 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’t

be built quickly. As Lou Lowenstein explains for U.S. accounting practices,
“our disclosure apparatus in all its parts—the accounting rules, the legal
profession, 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.
848 48 UCLA LAW REVIEW 781 (2001)
Some institutions can precede market development. Others will grow

only as the securities market grows. Many transition economies have few or
none of the core institutions discussed above. Where should they start?
One area of emphasis should be institutions that must be homegrown
and can precede market development. That effort can begin with honest
courts, regulators, and prosecutors, which are critical whatever form a coun-
try’s capital markets take. And government honesty is important for more
than 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 this
framework. Moreover, these rules can, in significant part, be imported from
outside. But the importing country needs to understand that if it engages
five sets of foreign advisors, they will propose five different laws, which will
be inconsistent with each other and with the country’s existing laws. Local
draftsmen need to be closely involved in the drafting process, to ensure that
the rules fit into the existing legal framework and build on existing termi-
nology and practice to the extent possible. Done right, this is a multiyear
process. Many countries rush it and botch the job, thereby lengthening the
time 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 countries
can draw on in preparing their own rules, or even adopt wholesale.
Another important long-term step, if reputational intermediaries are
weak or few in number, is to establish or strengthen business schools (for
investment bankers and accountants) and law schools (for securities lawyers
and regulators). The payoff from training young people will be measured in
decades. But if the investment isn’t made, the decades will go by, and the
country still won’t have the prerequisites it needs. Significant piggybacking
is feasible here—a country can establish a program (perhaps with foreign
aid 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, the
existence 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, ECONOMIC
DEVELOPMENT, LEGALITY, AND THE TRANSPLANT EFFECT (working paper, 1999), available at
http://papers.ssrn.com/paper.taf?abstract_id=183269 (Social Science Research Network). For
my 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 and
regulators, good disclosure rules, and the beginnings of a culture of honesty
before it makes sense to worry whether public company boards have, say, a
majority of independent directors.
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11-05-11 Black - The Legal and Institutional Foundations For Strong Capital Markets

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THE LEGAL AND INSTITUTIONAL PRECONDITIONS

FOR STRONG SECURITIES MARKETS

2. Specialized Institutions .......................................................................... 801

A strong public securities market, especially a public stock market, can

4. Three additional justifications for treating value maximization as a secondary concern

market-centered markets offer liquidity but weaker monitoring. I argue here

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

or a strong market equilibrium. Part VI develops the implications of my

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 and

B. The Core Institutions that Control Information Asymmetry

Countries with strong securities markets have developed a number

in a variety of countries.10 I present the list in an order that makes logical

Effective Regulators, Prosecutors, and Courts

(4) Extensive financial disclosure, including independent audits of public

(7) A sophisticated accounting profession with the skill and experience to

(9) A sophisticated investment banking profession that investigates securities

The lawyers’ role in disclosure is likely to depend on whether compa-

Company and Insider Liability

(16) Rules banning manipulation of trading prices (and enforcement of those

Culture and Other Informal Institutions

C. Additional Useful and Specialized Institutions

The list of core institutions in Part B reflects my personal judgment

a. Licensing of reputational intermediaries. It’s useful for accountants

investors) is likely to be more effective than public enforcement (through

rities market by providing a source of investable funds, as well as market and

For particular types of companies or preferred stock and debt, addi-

c. Money manager rating services. For money managers who manage

D. Which Institutions Are Necessary, Which Are Merely Nice to Have?

29. See Cheffins (2001), supra note 13.

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 the

B. The Core Institutions that Control Self-Dealing

Just as successful securities markets have developed institutions to

of core institutions for controlling information asymmetry into a single

Effective Regulators, Prosecutors, and Courts

Honest, decently funded judges, regulators, and prosecutors are, if any-

insiders to disprove self-dealing (once suspicious circumstances are established),

Disclosure Requirements and Procedural Protections

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

(8) Requirements that a company’s accountants review self-dealing trans-

transaction. Professionalism is one bulwark against this temptation, but liabil-

cipal civil sanction is liability to shareholders; regulators can also enjoin

Institutions to Control Insider Trading

(17) Rules ensuring transparent trading prices.

Culture and Other Informal Institutions

ing a seriously unfair transaction, or trading on inside information is improper and

To take a recent Russian example, it would never occur to an Ameri-

C. Additional Useful and Specialized Institutions

The list of core institutions in Part B reflects my personal judgment

c. Preemptive rights and redemption rights. Especially in a country with

III. PIGGYBACKING ON OTHER COUNTRIES’ INSTITUTIONS

An important question is to what extent can a company, located in

A. Estimating the Ease of Piggybacking

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

culture and honest, competent courts, regulators, and prosecutors—are the

Needed for: Piggybacking Ease:

Needed for: Piggybacking Ease:

16. Civil liability risk for

Needed for: Piggybacking Ease: