by Klaus J Hopt
1. Concept and scope of investor protection
For many centuries, investor protection has been the reaction to speculation, fraud on investors and stock exchange crashes. Laws for the protection of shareholders and investors have existed since the very beginning of the stock corporation and the stock exchanges. Traditionally, investor protection was primarily shareholder protection with some specific rules for stock exchange trading. True investor protection, ie protection of the investors who buy and sell publicly offered shares and debentures, has its roots in the United States securities regulations of the 1930s. Countries in Europe followed thereafter, first the United Kingdom and Belgium, and later France. In Germany, the concept of investor protection was only developed in the 1970s (Klaus J Hopt).
The concept of ‘investor’ reaches beyond investment in shares, debentures and investment funds and encompasses the investment in all publicly offered financial products. The concept of investor protection corresponds to this definition. The traditional shareholder protection by company law, ie protection within the organization, has been complemented with protection by securities regulation, ie protection on the markets. These markets no longer include just the stock exchanges but all relevant capital markets. The European term for securities regulation is therefore capital markets law, also encompassing takeover law. In capital markets law, one can distinguish between investor protection in the primary market, ie issuance of the shares, and in the secondary markets, ie when the shares and financial products are traded.
Investor protection in a larger sense includes depositor protection, though in legal terms there is a fundamental difference between shareholders who are members of the company and creditors who are mere partners to a commercial contract. Yet for the investor there is little difference whether he entrusts his savings to a bank or invests in an investment fund or buys shares. The latter is, of course, the most risky investment, but it correspondingly also promises the highest yields. Even when buying shares, investors usually start by being the creditors of a bank that buys the shares for them at the stock exchange. Looking at the rules on the solidity and responsible behaviour of banks and other financial intermediaries that are also performing an important service for the investing public, investor protection by company law and capital markets law is complemented by protection of the investors through banking law and the law of financial intermediaries.
2. Functions of investor protection, corporate governance
Investor protection aims at both protection of the individual investor (or the investor public) as well as protection of the market, called ‘functional investor protection’. Typical examples for individual investor protection can be found in stock corporation law, eg when individual shareholders or a minority of them have rights within the organization (voice) or on the market (exit, ie buying and selling). Yet individual investor protection also contributes to the good functioning of the capital markets and ultimately promotes the economy. In this sense, individual and functional investor protection are but two sides of the same coin. The key to investor protection is investor confidence as shown through all the long history of the companies and the stock exchanges. Telling examples are the tulip speculation in Amsterdam, the South Sea Bubble or the Mississippi Company and most recently the financial crisis of 2008–10. According to some writers, individual and functional confidence protection should be distinguished (Holger Fleischer). More recently, legislatures seem to prefer protecting the investors only via functional investor protection, ie without giving them individual rights or standing to sue. For example, this is the case for disclosure or the prohibition of market manipulation or stricter bank supervisory law as has been enacted everywhere as a consequence of the financial crisis. Though this is hardly ever openly conceded by the legislatures, it must be seen that most often this is done out of fear of incalculable financial risks and an opening of the floodgates to the courts. In any case, it is true that investor protection, like every legal protection, must not be exaggerated since otherwise dysfunctional effects arise. Thus investor protection against the wishes of the investor leads to paternalism, too much disclosure brings unnecessary financial burdens for the company or the bank, too much investor protection in the case of takeovers frightens off possible bidders and prevents bids that might be useful for the shareholders of the target company and for the economy as a whole. Similarly, at the stock exchange there must be segments with fewer requirements and investor protection, eg for start-up companies, risky investments and economically useful speculation.
The relevance of investor protection for the capital markets and the economy has long been well known. But more recently, American economists (Rafael La Porta, Florencio Lopez de Silanes, Andrei Shleifer, Robert Vishny: LLSV) have even claimed that there is a close relationship between the degree and quality of investor protection in a country and its financial development, and they provide empirical data for this claim: ‘[L]egal protection of outside investors limits the extent of expropriation of such investors by corporate insiders, and thereby promotes financial development’ (La Porta et al). They conclude that the Anglo-American legal orders are better than the continental European and other legal orders, in particular than the French and other Romanic ones. This is highly controversial—particularly, of course, in Europe—but also in the United States. One of the questions is causality, ie whether investor protection is the cause of financial development or the other way around. Under the impression of the financial crisis, even the partisans of this new theory concede that their thesis concerning investor protection, market, competition and globalization, while being sound in general and for normal times, must still be tested empirically for, and possibly adapted to, crisis situations.
Investor protection is not the same thing as corporate governance, though there are similarities. Corporate governance concerns not only the shareholders and investors, but also other persons or public goods involved in the governance of the company, such as labour or environment (stakeholders). But in corporate governance, too, the protection goes beyond the protection of individuals and groups and concerns the governance of the corporation more generally. While investor protection is basically a legal concept, corporate governance reaches out beyond law and is inherently interdisciplinary.
3. Typical investor risks
No investment is without risk. Typical investor risks are the risk of losing the investment, the information risk, the risk of investment administration, the risk of intermediation and the contract and price risk (Klaus J Hopt). The UK Financial Services Authority speaks of ‘prudential risk, bad faith risk, complexity or unsuitability risk and performance risk’, and one may add the systemic risk of the market (Holger Fleischer). In essence, the question is one of information and control.
Historically, the main risk for investors is the danger of totally or partly losing their investment in the company or their deposit with the bank or other financial intermediary. Share fraud and crashes of companies (eg Enron or Parmalat) or of banks and financial intermediaries (eg the German New Market or Lehmann Brothers 2008) are the most blatant forms of the risk of losing one’s investment. But there are less obvious forms of this risk, such as disregard of shareholder rights in the companies, the looting of a company, the illegal transfer of company assets or profits by the controlling shareholders to themselves or to companies belonging to the same group (known as tunnelling), the so-called starving of shareholders by systematically refusing to pay out dividends or the illegal squeeze-out.
Investors need information not only on the company itself, but particularly also when they invest or when they hold an investment (information risk). Without disclosure and transparency, shareholders cannot make proper use of their rights in the company or of the chance to sell their shares and to reinvest their money in another company or investment. Small investors are usually not in a position to make sensible investment decisions by themselves; they need disclosure and advice from financial intermediaries who are knowledgeable and not in a position of conflict of interest.
The risk of investment administration lies in the various practices that work to the disadvantage of investors when the investment transaction is carried out (such as unnecessary fee-bringing transactions on behalf of the client, called churning), but also independently of a transaction (eg manipulation of the stock price or the market (market manipulation)).
The risk of intermediation arises, for example, if investors mandate their bank or another proxy to exercise their voting rights at the general meeting and the intermediary does not act in the interest of the investors. This risk exists particularly if the intermediary has a conflict of interest.
The contract and price risk concerns the price asked for and the business conditions offered by the companies, banks and other financial intermediaries. Part of this refers to the clauses of exoneration for liability for malperformance or a lack of or bad advice. Such clauses are often hidden in the standard contract terms found in the forms of the bank or financial intermediary.
4. Legal and extralegal instruments of investor protection
Investor protection, as well as any protection of the weaker party, eg of consumers, can be carried out in many different ways, partly by law, partly by extralegal instruments. The best investor protection is still the personal responsibility of investors themselves. Yet here the insights of modern behavioural finance must be taken into account. This is particularly relevant for the contract and price risk. In a market economy, the most important contract condition—the price—is left to the market, with the exception of usury and other extreme limits. As far as information is concerned, the personal responsibility of investors is the starting point. Investors may refuse information and advice or may nevertheless choose risky investments in hopes of benefiting from high yields. There is also a collective responsibility for market confidence, as shown by private rule-making and codes of conduct.
Disclosure and transparency are the legal rules that enable investors and the market to judge for themselves how things are with the company and the investment. They are the least interventionist and conform most to the market economy. Mandatory disclosure rules have a long tradition. In company law, they date back to the Gladstonian reforms of 1844 in England. As far as the stock exchanges and the capital markets are concerned, the US securities regulations of the 1930s have been the model for all later capital markets laws and regulations in the world. Disclosure is only as good as it is reliable. Therefore, auditing, voluntary or mandatory, contributes towards creating and maintaining the confidence of investors and the market.
Investor protection rules of a very different kind exist in company and organizational laws (voice), in stock exchange and capital markets laws (exit), in banking law and the law of financial intermediaries, including investment law and the law of banking, insurance and securities markets supervision. The depositor protection rules and various insurance schemes also belong here, as well as more generally the regulation of access to the market, market behaviour, competition and the separation of investment banks and credit banks.
Last but not least, general civil rules protect the investors, eg by liability imposed if company or capital markets law rules are infringed or in case of fraudulent behaviour. Procedural law is also important for investor protection, eg access to court, due process, reasonable length of proceedings and enforcement. Here there are particular weaknesses and gaps in the laws of many developing countries.
European harmonization of the shareholder and investor protection law consists mainly of a considerable number of company law harmonization directives. Yet unlike the harmonization of stock exchange and capital markets law, company law harmonization is less advanced, though it is open to controversy as to whether this is good (competition between legal systems) or even legally mandated (subsidiarity principle in European law). In any case, it is a fact that European company law with a few exceptions covers only listed companies. Unlisted public companies, and even less so private companies, are not covered. Even for listed companies, core parts of company law and shareholder protection law are not or are only very selectively harmonized, eg the law of the company organs (board), the competences of the general meeting and the law of groups of companies. The plans of the European Commission to harmonize core company law by a 5th Directive on the structure of the public company and by a 9th Directive on groups of companies have, for now, been abandoned. For details and more sources of investor protection and European company law, company law and stock corporation.
European company law usually aims, directly or indirectly, at the protection of shareholders. Examples are the 2nd Directive of 13 December 1976 (Dir 77/91); the so-called Capital Directive, which mandates the raising and maintenance of the capital for the company and most recently has become highly controversial; the 4th and 7th Directives of 25 July 1978 (Dir 78/660) and 13 June 1983 (Dir 83/349) concerning annual accounts and consolidated accounts; the 8th Directive on statutory audits of 10 April 1984 (Dir 84/253; this Directive has been replaced by the Directive of 17 May 2006 on statutory audits, Dir 2006/43); the Regulation on the application of international accounting standards of 19 July 2002 (Reg 1606/2002); and the two recommendations concerning the board of 14 December 2004 on board members’ remuneration (Recommendation 2004/913, including the modification by the recommendation of 30 April 2009 (Recommendation 209/385) and of 15 February 2005 on directors and committees of the board (Recommendation 2005/162). As to the former, see also the recommendation of 30 April 2009 on remuneration policies in the financial sector (Recommendation 2009/384). The Directive of 11 July 2007 on the exercise of certain rights of the shareholders of listed companies (Dir 2007/36) should also be mentioned. The Action Plan of the European Commission of 21 May 2003, which goes back to the work of the High Level Group of Company Law Experts, gives an idea of the work envisaged for modernizing company law and enhancing corporate governance in the European Union. The short-term measures contained in the Action Plan have already been enacted by several directives and recommendations. It remains to be seen whether the new Commission will take up some of the other measures. For details, corporate governance.
6. European harmonization of investor protection
European harmonization of investor protection that goes beyond shareholder protection is much further advanced. Originally this harmonization covered only the stock exchange law with four Directives of 1979, 1980, 1982 and 1988 concerning the admission of securities to official stock exchange listing (Dir 79/279), the prospectuses and other requirements for admission of securities to official stock exchange listing (Dir 80/390), the information to be published on a regular basis by companies whose shares have been admitted to official stock exchange listing (Dir 82/121) and the information to be published when a major holding in a listed company is acquired or disposed of (Dir 88/627). These Directives were consolidated in the Stock Exchange Listing Directive (Dir 2001/34). For details and further legal sources on investor protection by European stock exchange law, exchanges.
More recently, European harmonization moved its focus from the stock exchange to the capital markets. In 1993, the Investment Services Directive was enacted. This Directive was replaced by Dir 2004/39 of 21 April 2004 on markets in financial instruments (MiFID, Markets in Financial Instruments Directive). This Directive has become the basic law of financial markets in Europe. In the meantime, it has been transposed into the various Member State laws. Other important directives promoting investor protection deal with insider trading, market manipulation and takeovers. For details and further legal sources on investor protection by European stock exchange law, capital markets law.
Klaus J Hopt, Der Kapitalanlegerschutz im Recht der Banken, Gesellschafts-, bank- und börsenrechtliche Anforderungen an das Beratungs- und Verwaltungsverhalten der Kreditinstitute (1975); Richard M Buxbaum and Klaus J Hopt, Legal Harmonization and the Business Enterprise: Corporate and Capital Market Law Harmonization Policy in Europe and the USA (1988); Susanne Kalss, Anlegerinteressen, Der Anleger im Handlungsdreieck von Vertrag, Verband und Markt (2001); Holger Fleischer and Hanno Merkt, ‘Empfiehlt es sich im Interesse des Anlegerschutzes und zur Förderung des Finanzplatzes Deutschland das Kapitalmarkt- und Börsenrecht neu zu regeln?, Gutachten F und Gutachten G’ in Ständige Deputation des Deutschen Juristentages (ed), Verhandlungen des vierundsechzigsten Deutschen Juristentages, vol I (2002); High Level Group of Company Law Experts, Report on Issues Related to Takeover Bids (Report I) and A Modern Regulatory Framework for Company Law in Europe (Report II), Reports of the High Level Group of Company Law Experts, European Commission, Brussels, 10 January 2002 and 4 November 2002, available also in Guido Ferrarini, Klaus J Hopt, Jaap Winter and Eddy Wymeersch (eds), Reforming Company and Takeover Law in Europe (2004) Annex 2, 825 ff and Annex 3, 925 ff; Paul Frentrop, A History of Corporate Governance 1602–2002 (2003); Guido Ferrarini and Eddy Wymeersch (eds), Investor Protection in Europe (2006); Stefan Grundmann and Florian Möslein, European Company Law, Organization, Finance and Capital Markets (2007); Klaus J Hopt and Eddy Wymeersch (eds), European Company and Financial Law, Texts and Leading Cases (2007); Klaus J Hopt, ‘Comparative Company Law’ in Mathias Reimann and Reinhard Zimmermann (eds), The Oxford Handbook of Comparative Law (2008) 1162 ff; Rafael La Porta, Florencio Lopez de Silanes and Andrei Shleifer, ‘The Economic Consequences of Legal Origins’  JEL 285.