The Controlling Shareholder as Reputational Intermediary

Abstract

Informal institutions can promote relations of trust between listed firms and outside investors. Trust, in turn, is essential to neutralize adverse selection in capital markets, a function that becomes particularly relevant in nations with defective legal systems. This paper looks at how reputational intermediation, an informal institution, can give rise to these relations of trust in emerging countries. The main argument put forward here is that certain types of controlling shareholder have financial incentives to deal fairly with their minority counterparts even in the absence of enforceable legal rules of investor protection. Under the right conditions, these incentives might induce trust between market participants in a manner propitious to stock market development. By exploring the role of controlling shareholders as reputational intermediaries, this paper calls for policymakers to properly consider informal institutions when designing their reform agendas for developing countries.