A Survey of Securities Laws and Enforcement
| Author | Florencio Lopez-de-Silanes |
| Profession | YALE University and NBER |
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I am indebted to Patricio Amador, Jose Caballero and Manuel Garcia-Huitron for their comments and excellent research assistance. I would also like to thank the Global Corporate Governance Forum and the International Institute of Corporate Governance at Yale University for funding. This paper draws on my previous work with several coauthors, including Simeon Djankov, Simon Johnson, Rafael La Porta, Andrei Shleifer and Robert. W. Vishny.
Securities laws have long been a controversial issue. An important tradition in law and economics, originating in the work of Coase (1960) and Stigler (1964), and most clearly articulated in the context of financial markets by Easterbrook and Fischel (1984) and Macey 1994), holds that securities laws are either irrelevant or damaging. According to this tradition, financial transactions take place between sophisticated issuers and investors and therefore market mechanisms suffice to ensure that securities markets prosper. To obtain the highest price for the shares they sell and to avoid sanctions, Issuers have incentives to disclose accurate information. Investors have an interest in collecting and analyzing relevant information regarding the securities they wish to purchase and to do so only form reputable firms as to avoid being cheated. Securities laws, therefore, are either irrelevant, to the extent that they codify existing market arrangements or damaging, in so far as they raise costs and interfere with the optimal functioning of markets.
An alternative tradition argues that "law matters", and securities laws in particular are important market-supporting institutions. This argument has a long tradition in regulatory economics (Landis 1938, Friend and Herman 1964), and has recently been rejuvenated by a new generation of legal scholars (Coffee 1984, 1989, 2002, Mahoney 1995, Fox 1999, Black 2001, Beny 2002). According to this viewpoint, general law and private contracting are insufficient to keep promoters from cheating investors because the incentives to misbehave may overrule the "long run" benefits of honesty and because private litigation may be too expensive and unpredictable to serve as a deterrent (see, e.g., Djankov et al. 2003). To reduce enforcement Page 3 costs and opportunistic behavior, a regulatory and contracting framework dictated by securities laws is required.
Recent empirical evidence supports this position. Glaeser, Johnson, Shleifer (2001) point to differences in securities laws to explain why securities markets stagnated in the Czech Republic but developed quickly in Poland during their transition from socialism. Coffee (1999), Siegel (2002), Stulz (1999), Doidge et al. (2001), Mitton (2002) and Reese and Weisbach (2002) examine the role of ADRs as bonding mechanisms and show that firms that have them are more valuable and have better access to external finance than do firms from the same country not listed in the US. This argument is also supported by Bhattacharya and Daouk (2002) who show that the cost of equity in a country decreases significantly after the first enforcement of insider trading laws and by La Porta et al. (1997, 1998), who find that countries with better legal protections of investors have better developed financial markets.
Enforcement of securities laws depend crucially on two pillars: the characteristics and powers of the regulator and the efficiency of courts. It has been argued that particular characteristics of the regulator make them more or less efficient (Holmstrom and Milgrom, 1991; Spiller and Ferejohn, 1992; Johnson, Glaeser, and Shleifer, 2001 and Pistor and Xu, 2002 among others). The effectiveness of a regulator depends on its degree of independence from the executive and on its degree of specificity. A regulator that is independent of the executive will probably be able to resist political pressure; while a regulator that is dedicated specifically to the securities market runs less risk of being distracted by other concerns. The powers of the regulator are also of vital importance. The Regulator's investigative powers, its right to sanction misconduct and the ability to command documents, prevent certain actions and impose criminal Page 4 sanctions may make a difference in the behavior of financial markets. In this paper, I explore the issues raised above to distinguish which characteristics are truly important and which are superfluous. This type of analysis is of great importance when designing or reforming a regulatory institution because important factors are often overlooked while other characteristics that matter only marginally receive attention. Criminal Sanctions, for example, are hailed as a vital reform for efficient securities regulation none withstanding the fact that empirical evidence shows that their actual impact is negligible.
The second pillar of the enforcement of securities laws is the courts system. The outcome from securities laws depends on the efficient execution of these laws through the courts system. Although the enforcement of securities rights and of property rights in general is crucial for economic development, theory alone is not sufficient to determine which mechanism is optimum. No system is perfect, therefore we need to analyze each to determine which one is optimum for a particular situation. Private enforcement works well in certain circumstances, but runs the risk of degenerating into violence. Public enforcement is also effective, but runs the risk of being "captured" by special interests or unduly influenced by agents with political power. There are three basic theories about the origins of a legal system. The "development theory" argues that courts, like all institutions, are a fixed cost and will thus not develop efficiently until an appropriate level of development is reached (Demsetz, 1967; North 1981). According to this theory, a poor society will seldom have an efficient legal system while a rich one will. The "incentive" theory of courts holds that the incentives of the participants shape the outcome and the efficiency of the legal system (Messick, 1999). Courts will work poorly if agents are given incentives to drag out legal processes or to resort to litigation to resolve trivial Page 5 matters, while thy will work efficiently if there are incentives to resolve disputes expediently and agents must face the costs of resorting to the legal system (i.e., looser pays the legal fees). The third theory is "procedural formalism" and argues that the core characteristics of most legal systems are not endogenous but were transplanted years ago from a limited family of legal families (Djankov, La Porta, Lopez-de-Silanes and Shleifer, 2003). This paper follows the procedural formalism theory and explores the relationship between the inherited level of judicial formalism and its effect on financial markets.
Following the introduction, section2 reviews the theoretical literature on the relevance of securities laws and stock market regulations and their enforcement. Section 3 reviews some recent empirical studies on insider trading laws and their enforcement, the impact of improved disclosure through cross-listing, and the relevance of securities laws for initial public offerings. Section 3 also establishes the basis fro the analysis of the impact of enforcement through two channels: first, regulatory sanctions or actions by the market regulator and, second private litigation through the court system. Finally, section 4 presents some preliminary conclusions and suggest areas for further work in the field.
The theoretical literature has long argued the relative merits and disadvantages of securities laws. Many scholars insist that regulation of securities is beneficial because it protects investors by mandating disclosure and that it foments the growth of markets by increasing the supply of truthful information. However, not everybody is convinced by these arguments and instead believe that securities laws are either irrelevant, because they contribute nothing the Page 6 market has not taken into account already, or damaging, because they restrict certain kinds of transactions and increase the costs of doing business.
Easterbrook (1984) analyses the effects of the securities acts of 1933 and 1934 and claims that, although securities regulation and mandatory disclosure of relevant information could lead to more efficient market outcomes, there is no evidence that existing Securities and Exchange Commission (SEC) rules have improved market efficiency. Macey (1994) criticizes securities regulation and regulators, the SEC particularly, because he feels that these institutions have fallen into obsolescence. Both authors agree that securities regulations have the potential to be market enhancing institutions, but that in their current form they do more harm than good. Easterbrook (1984) claims that it is more likely that securities regulation protect and benefit special interest groups and other vested interests than investors. Disclosure rules, for example, give large firms a competitive edge over their rivals since the cost of disclosure is mostly independent of firm size. Investment banks and audit firms also benefit from regulations because all firms that wish to list on the stock exchange need to purchase their products. Instead of allowing firms to explore alternate paths to the market, all must settle for what regulators deem the "best path." Macey (1994) acknowledges that current regulations were probably beneficial at their inception to assuage the fear brought about by the 1929 stock market crash, but argues that technological and administrative change have made them obsolete. Instead of reducing transaction costs and...
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