LEGAL PROTECTIONS FOR INVESTORS: A PRIORITY FOR THE
In connection with the goal to “promote further legal convergence in the area of
inter-American business transactions” (SLA/OAS-CIDA Project Background Paper), this
paper addresses the needs in the area of investor rights. For reasons stated in the body of the
paper, the focus is on the capital market and the protection of investors in shares.
The modern corporation depends on a healthy capital market in order to meet the
competitive needs of a global society, and investors in the capital market depend on adequate
legal protections in order to participate in the capital market. Investor protections may take
many forms, and it is important to assure that the forms adopted are effective and are
perceived as effective by the investors themselves. What should be the goals of the OAS
member states in strengthening those protections throughout the hemisphere?
Laws Protecting Investors are Important for Economic Development and Growth
It is well established that a country’s financial system plays a key role in its
economic growth and stability. It is also acknowledged that the capital market is a key part
1of any financial system. Scholars generally agree that the size and breadth of the capital 23market affects economic development and growth. As noted in a recent scholarly paper:
* * * In countries with strong shareholder protection, investors can afford
to take minority positions rather than controlling stakes. As a result, firms
tend to have dispersed shareholders as owners, and capital markets are
rather liquid. By contrast, where shareholder rights are not well protected,
* Mr. Allan Roth is Professor emeritus at Rutgers University and possesses extensive experience in
providing consulting services on legal and financial reforms around the world. 1 Thorsten Beck and Ross Levine, “Stock Markets, Banks, and Growth: Correlation or Causality,” World Bank Working Paper #2670 (July 2001); Thorsten Beck, Aslý Demirgüç-Kunt, Ross Levine
and Vojislav Maksimovic, “Financial Structure and Economic Development: Firm, Industry, and
Country Evidence,” World Bank Working Paper #2423 (June 2000) [http://econ.worldbank.org]. 2 Thorsten Beck and Ross Levine, “Stock Markets, Banks, and Growth: Correlation or Causality,” World Bank Working Paper #2670 (July 2001) [http://econ.worldbank.org]. 3 Katharina Pistor, “Patterns of legal change: shareholder and creditor rights in transition
economies,” European Bank for Reconstruction and Development Working paper #49 (2000), citing
A. Shleifer and R.W. Vishny, "A Survey of Corporate Governance", 52 Journal of Finance 737-783
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investors will compensate this deficiency by taking controlling stakes. This
leads to high levels of ownership concentration.
In addition to studies from a macroeconomic vantage, research shows that financial
market development is especially important for small firms and for the formation of new
enterprises. Inadequately developed financial systems also hinder large firms by limiting the 4availability of long-term capital. Well functioning financial markets facilitate access to
external funds for firms with good investment opportunities. The resulting improved 5efficiency in the capital allocation process enhances economic growth.
Extensive research by economists and lawyers confirms the significant impact that
law and legal institutions have on the financial system’s development and growth. The 6Nobel laureate Douglass C. North, highlighting the important relationship between a
country’s legal institutions and its economic development, emphasized that secure property
rights are critical for capital markets to develop and flourish. In turn, secure property rights
“require political and judicial organizations that effectively and impartially enforce contracts 78across space and time.” In the words of one scholarly study:
* * * [T]he legal rights of outside investors and the efficiency of the legal
system in enforcing those legal rights is strongly and positively linked with
GDP growth, industrial performance, new firm formation, and firm growth.
The legal system importantly influences financial sector development and
this in turn influences firm performance, the formation of new firms, and
national growth rates.
They conclude that “policy makers should . . . focus on strengthening the rights of 9outside investors and enhancing the efficiency of contract enforcement.”
Of particular interest is a series of studies conducted by Professors Rafael La Porta,
Florencio Lopez-de-Silanes, Andrei Schleifer and Robert Vishny that highlight the 10importance of legal protections for investors. A 1996 study concluded that the
4 Inessa Love, “Financial Development and Financial Constraints: International Evidence from the
Structural Investment Model,” World Bank Working Paper #2694 at 24, Sept.200.
http://econ.worldbank.org 5 Id. at 3. 6 Douglass C. North, Institutions, Institutional Changes And Economic Performance (Cambridge
University Press: 1990). 7 Id. At 121. 8 Thorsten Beck, Aslý Demirgüç-Kunt, Ross Levine and Vojislav Maksimovic, “Financial
Structure and Economic Development: Firm, Industry, and Country Evidence,” World Bank Working
Paper #2423 at 6(June 2000). 9 Id. at 6-7. See also, Beck, Demirgus-Kunt and Levine, “Law, Politics and Finance,” World Bank
Working Paper #2585 (Feb. 2001). 10 Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Schleifer and Robert Vishny, “Legal
Determinants of External Finance, 52 Journal of Finance 1131 (1997); Shleifer and Vishny, “A
Survey of Corporate Governance,” 52 Journal of Finance 52 (1997); La Porta, Lopez-de-Silanes and
Schleifer, “Corporate Ownership Around the World,” 54 Journal of Finance 471 (1999); La Porta,
Lopez-de-Silanes, Schleifer and Vishny, “Investor Protection: Origins, Consequences, Reform,”
National Bureau of Economic Research Working Paper #7428 (1999) [http://www.nber.org/papers].
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effectiveness of a financial system is correlated to the legal rules protecting investors and the 11quality of the enforcement of those rules. In the words of the authors [emphasis in the original]:
The rights attached to securities become tremendously important once it is
recognized that managers of companies act in their own interest.
Investors’ rights give them the power to extract from these managers the
returns on their investment. Thus shareholders receive dividends because
they can vote out the directors who do not pay them, and creditors are paid
because they have the power to repossess collateral. Without these rights,
investors would not be able to get paid, and therefore firms would not have
the benefit of raising funds from these investors. The rights attached to
securities are what managers and entrepreneurs give up to get finance.
But the view that securities are inherently characterized by some intrinsic rights is
incomplete as well. It ignores the obvious point that these rights depend on the legal rules of
the jurisdictions where these securities are issued. Does being a shareholder in France give
an investor the same privileges as being a shareholder in the United States, India, or Mexico?
Would a secured creditor in Germany fare as well when the borrower defaults as one in
Taiwan or Italy, assuming that the value of the collateral is the same in all cases? Law and
the quality of its enforcement are potentially important determinants of what rights security
holders have and how well these rights are protected. Since the protection investors receive
determines their readiness to finance firms, corporate finance may critically turn on these
legal rules and their enforcement.
12In a succeeding study, the same scholars compared a sample of 49 countries according to a measure of the quality of legal protections for investors and of law
enforcement in those countries. They concluded that the “legal environment has large 13effects on the size and breadth of capital markets across countries.” In the absence of
effective legal protections, the capital market does not attract small, diversified investors.
Summarizing the various reported research, a recent World Bank working paper 14concluded:
Professors La Porta, Lopez-de-Silenes and Schleifer are at Harvard, Professor Vishny is at the
University of Chicago. 11 La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Law and Finance,” National Bureau of
Economic Research Working Paper #5661 at pp. 2-3(1996). 12 La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Legal Determinants of Growth,” 52 Journal of Finance 1131 (1997). 13 Id. at 1132; see also, Katharina Pistor, “Patterns of legal change: shareholder and creditor rights
in transition economies,” European Bank for Reconstruction and Development Working paper no. 49
(May 2000); La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Investor Protection: Origins,
Consequences, Reform,” National Bureau of Economic Research Working Paper #7428 (1999)
(published as “Investor Protection and Corporate Governance,” 58 Journal of Financial Economics 3
(Oct. 2000). 14 Thorsten Beck, Aslý Demirgüç-Kunt, Ross Levine and Vojislav Maksimovic, “Financial
Structure and Economic Development: Firm, Industry, and Country Evidence,” World Bank Working
Paper #2423 at p. 40 (June 2000).
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* * * Economies grow faster, industries depending heavily on external
finance expand at higher rates, new firms are created more easily, firms’
access to external financing is higher, and firms grow more rapidly in
economies with a higher levels [sic] of overall financial sector
development and in countries with legal systems that more effectively
protect the rights of outside investors.
The Modern Corporation is Dependent on a Developed Capital Market
The limited liability enterprise, or “corporation”, is designed to facilitate raising
capital from outside investors. The attribute of limited liability for the investors is designed
to encourage strangers to the enterprise to contribute capital. The governance structure of
the corporation is designed to allow a separation of management and ownership and for the
professionalization of management.
The modern corporation requires outside capital to achieve optimum levels of
efficiency and to meet the needs of global competition. The absence of effective financial
markets creates distortions in the economy that reduce competitiveness. For example, in one
country in which the author served as a technical advisor, businesses—especially small- and
medium-sized businesses-lacked sources of long-term capital. Some of the resulting
distortions were noted by the author as follows:
Business firms--both large and small--tend to rely heavily on internal
financing. Managers of several firms with whom we spoke were proud of
the low external debt carried by their firms. This means that capital
expansion is either to be financed by retained earnings, rolled-over bank
overdrafts or some combination of the two. This can be expected to inhibit
managements from expanding the scale of their operations, with the result
that firms may not achieve optimum scales of operations to maximize
efficiencies. Alternatively, the need to generate investment capital from
earnings impels managers to set high profit margins--which seems a
common practice--with the result that prices are high. When coupled with
the pressure on management to pay a large percentage of earnings as
dividends, this pressure to generate high levels of profits to provide
working capital and expansion capital is accentuated.
Investors are more inclined to provide the needed capital where they are afforded
adequate legal protections. La Porta et al find that that “the [legal] protection investors
receive determines their readiness to finance firms,” and they show that the legal
environment significantly affects the size and breadth of capital markets across countries.15
By diminishing financing constraints, effective legal protection allows for more efficient
15 La Porta, Lopez-de-Silanes, Shleifer and Vishny, “Investor Protection: Origins, Consequences,
Reform,” National Bureau of Economic Research Working Paper #7428 (1999) (published as
“Investor Protection and Corporate Governance,” 58 JOURNAL OF FINANCIAL ECONOMICS 3
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Civil and Common Law Distinctions
The research of Professors La Porta, Lopez-de-Silanes, Shleifer and Vishny
indicates that investor protections are stronger and more effective in common law countries 16than in the civil law countries. They also examined the quality of the enforcement of the
laws to protect investor in various countries, considering the quality of enforcement in terms
of the efficiency of the judiciary and the quality of accounting standards. From this
examination, they concluded that while enforcement generally is more effective in affluent
countries than in economically less developed countries, countries following the French civil
law tradition have the “worst quality of law enforcement” among the groups of legal systems 17studied. In short, the type of legal system appears more important to the effectiveness of legal protections for investors than the level of economic development.
The reason for the disparity between common law and civil law countries in the
quality and effectiveness of investor protections is speculative. These scholars suggest two 18lines of analysis: Judicial and political.
The judicial explanation is that judge-made law is inherent in common law systems, and judges are at liberty to evolve new standards of conduct in the face of new types of
behavior by corporate managers and other insiders. Civil law judges are more constrained in
evolving new standards since they are dependent upon the legislature to initiate the
formulation of rules and standards. The common law judges, then, are more pro-active on
behalf of investor protections than their civil law counterparts.
The political explanation focuses on the differences in the historical development of the countries that originated the common and civil law traditions. In England, where the
Crown gradually lost power over the courts to Parliament and the landed interests, the judges
perceived their role to be the protectors of private rights against interference by the Crown.
In France and Germany, it is argued, the kings were never dominated by the legislature, and
the state interest continued to dominate the courts. Civil law courts, therefore, were less
likely than common law courts to side with investors over the state or the commercial
19interests aligned with the state.
The conclusion of this research is that “the nature of investor protection, and of
regulation of financial markets more generally, is deeply rooted in the legal structure of each
country, and in the origin of its laws. Reform on the margin may not successfully achieve 20the reformer’s goals.”
16 Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny, “Legal
Determinants of External Finance,” 52 JOURNAL OF FINANCE 1131, 1149 (1997); La Porta,
Lopez-de-Silanes, Shleifer and Vishny, “Investor Protection: Origins, Consequences, Reform,”
National Bureau of Economic Research Working Paper #7428 at 8 (1999) (published as “Investor
Protection and Corporate Governance,” 58 JOURNAL OF FINANCIAL ECONOMICS 3 (Oct. 2000). 17 La Porta et al, NBER Working Paper #7428 supra n. 16 at 9. 18 Id. at 9, 10-13. 19 Id. at 11. 20 Id. at 32.
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Those who would reform the laws providing investor protection must be mindful of
these factors. Not only must the text of the law be changed, but the attitudes of lawyers and
judges must be influenced to embrace the changes and the underlying reasons for them.
What should be the Goals of the OAS Member States in Strengthening Investor
Protections throughout the Hemisphere?
As national borders become less relevant to financial markets and investment, the
laws and practices by which those markets are structured are becoming more integrated.
One need point only to the European Union's harmonization of securities laws, the growing
influence of the International Organization of Securities Commissions, the United
States-Canadian Multijurisdictional Disclosure System and the WTO Understanding on
Trade in Financial Services to highlight the transnationality of financial markets and
institutions. Indeed, one commentator has suggested that domestic laws regarding securities
disclosure should be replaced “with unified disclosure standards to be used by domestic and
21foreign issuers in all developed markets.”
At one time, it was feared that freely allowing borders to be crossed would result in 22a “race to the bottom” by regulators; business would flock to the jurisdiction that had the
least regulation. That view has given way to the opposite expectation; experience has not
borne out the prediction of a race to the bottom. Because effective regulation produces more
efficient markets, competitive forces make the more regulated jurisdictions more attractive,
not less. Professor Coffee, for example, suggests that foreign companies eagerly submit to
the world’s most rigorous securities laws to gain the economic advantages of the U.S. 23market.
It is thus in the interests of the OAS member states to strengthen their respective
laws providing protections for investors. Indeed, over the past three decades, vigorous
efforts at strengthening these laws have been made in a number of member countries. It is
now time to coordinate this effort on a multinational basis to facilitate cross-border
investment and enhance economic growth domestically and regionally. The OAS could
provide the impetus for this effort.
If there is to be some effort to integrate or coordinate the investor protective laws in
the OAS member states, there are choices to be made. Since investor protections have been
demonstrated to be so critical to economic development, it would follow that the countries
with the most effective investor protective laws would have a competitive advantage. Other
countries would want to improve their legal protections for investors to equalize their
21 Uri Geiger, “Harmonization Of Securities Disclosure Rules In The Global Market—A Proposal,”
66 FORDHAM L. REV. 1785, 1786-87 (1998). 22 William Cary, “Federalism and Corporate Law: Reflections Upon Delaware,” 83 YALE L.J. 663,
666 (1974). Cf. Ralph Winter, Jr., “State Law, Shareholder Protection And The Theory of The Firm,”
6 J. LEGAL STUD. 251,, 254-262 (1977). 23 John C. Coffee, Jr., “The Future As History: The Prospects for Global Convergence in Corporate
governance And Its Implications,” 93 NW. L.REV. 641 (1999).
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24competitive positions. This is the reasoning of those who urge “convergence” of law.
Convergence has been described as a “dynamic of institutional change” whereby
“competition between systems and institutions will over time self-select the most effective 25institutions, and different systems will converge on these.” A counter view is that
“institutions develop along path dependent trajectories. Institutional change is incremental
and shaped by pre-existing conditions. Thus, systems will continue to diverge rather than 26converge.” Both are essentially reactive strategies - how will institutions develop if left on their own.
A more pro-active approach could be through “harmonization” of laws. Harmonization may be through reciprocity or commonality (uniformity). Using disclosure
requirements to illustrate the point, with reciprocity, if the disclosure satisfies the
requirements of the home country, it will be acceptable in the host country. With
commonality, all countries strive to achieve agreed upon standards and procedures for
27 The European Union has used both. Through a series of directives for member
countries to adopt basic provisions in their laws, the EU has set minimum standards for the 28entire common market. Each member is free to adopt more extensive or stringent
requirements, but the minimum standards assure a level of investor protection that is
acceptable to all members. This is the commonality element.
Under the EU directives, compliance with the requirements of any member state
must be accepted by any other member state. For example, if a prospectus meets the
requirements of the German law and has been approved by the appropriate German authority,
it must be accepted as valid in France. This is the reciprocity element.
The EU could have set minimum standards without requiring compliance in one
country to be acceptable as compliance in every other country. Reciprocity does encourage
“arbitrage”, if not a race to the bottom. Why bother to comply with the more stringent
requirements when complying with the least stringent requirements, through reciprocity,
allows full access to the market where the requirements are most stringent?
Accordingly, when reciprocity is dependent upon adherence to harmonized
minimum standards that meet the test of world-wide best practices, it need not produce
regulatory arbitrage. For example, the OAS member states might agree upon fairly rigorous
common requirements for a prospectus and then agree that any prospectus meeting the
minimum requirements and accepted in any other member state would qualify as meeting the
24 Ibid. 25 Katharina Pistor, “Patterns of legal change: shareholder and creditor rights in transition
economies,” EBRD Working paper #49 (May 2000) at p. 3. 26 Ibid. 27 See generally, Uri Geiger, “Harmonization Of Securities Disclosure Rules In The Global
Market—A Proposal,” 66 FORDHAM L. REV. 1785 (1998). 28 Council Directive 93/22 1993 O.J. (L. 141) 27; Council Directive 89/298, 1989 O.J. (L. 124) 8;
Council Directive No. 87/345, 1987 O.J. (L 185) 81; Council Directive No. 82/121, 1982 O.J. (L 48)
26; Council Directive 80/390, 1980 O.J. (L.100) 1.
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requirements in every other state.
A similar approach may be applied with respect to standards for the competence and financial accountability of capital market professionals. A broker qualified in one member
state by reason of passing required examinations and meeting minimum capital requirements
that conform to harmonized common standards could be permitted to transact in another
member state-either directly or through a domestically qualified broker.
On the other hand, harmonization in the form of uniformity, rather than
commonality, might be better in connection with accounting standards. Variations in
accounting standards and practice by country are impediments to cross-border transactions.
Where countries have significant policy differences with respect to financial reporting, these
differences ought to be susceptible to accommodation within a common set of accounting
standards and practices.
If the OAS member states are to be pro-active in the area of laws providing investor
protection, what is the nature of the protection to be provided?
Types of Legal Protections for Investors
It becomes the task of the legal system to devise appropriate forms of protection for investors and to assure the protections provided are effective. It may be useful to distinguish
between protections related to the investment process and protections as shareholders--
usually small, minority holders-in connection with the management of their investment in
In the first instance, equity investors are savers willing to enroll those savings in the capital markets by buying shares. Accordingly, one set of protections is related to the
investment process itself. These are issues of securities regulation under the laws of most
countries, and for instance include disclosure requirements, availability of dependable
professionals, a liquid trading market and effective enforcement mechanisms.
In the second instance, once the saver has purchased securities and has become a shareholder in a company, protections are needed as a minority shareholder. These are the
issues related to corporate governance, such as voting rights, governing board structures, exit
mechanisms and the adequacy of investor remedies, and are dealt with in company/corporate
law or commercial law.
In the literature of corporate governance, investor protections are sometimes distinguished as “voice” or “exit” strategies.29 By exit strategy is meant protecting the
shareholder’s right to sell out of the investment if he/she is dissatisfied. “Voice” strategies
focus on protecting the shareholders’ capacity to hold company management to account
through shareholders’ statutory rights.
29 Katharina Pistor, “Patterns of legal change: shareholder and creditor rights in transition
economies,” European Bank for Reconstruction and Development Working paper No. 49 p.10 (May
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1. Protections related to the investment process (securities regulation)
The protections needed to attract average citizens to participate in the capital markets are often provided in separate, securities laws. The laws governing the formation
and operation of companies typically also include provisions designed to protect the public
in the investment process. Among the latter are provisions against watered stock, assuring
full funding of founder shares, etc.
Any system of investor protections needs both to provide adequate protection in fact and to enable small investors to feel protected. At the same time, it is important to set
realistic levels of public expectation; care must be taken not to promise more than can be
delivered, or the two objectives come into conflict. In the light of this, against what risks
can, and should, average investors be protected?
Disclosure as investor protection
In some jurisdictions, investor protection is in the form of a government agency's "merit review" of a proposed offering of securities to the investing public. For example, at
one time, some laws required that, before a public offering of securities could be made, an
administrator had to find the proposed offering to be “fair, just and equitable” to prospective
investors. Under this standard, the administrator had wide latitude to evaluate the merits of
To the extent that merit review laws are sought to be applied to protect investors against the risk of investment loss, they are unrealistic and unworkable: An investor in a
business is inherently at risk as to how well the business will prosper; this aspect of
investment needs to be understood by every investor at the outset. If an attempt were made
to shield investors from being invited to invest in businesses that are too risky, the question
invariably arises as to what degree of risk is excessive--and who is to decide? Some
investors are willing and able to assume high levels of risk in the hope of high levels of
rewards. Some businesses are very risky, yet, from risky new ventures often come new
technologies and new products. To deny these high-risk businesses the opportunity to
compete for capital could choke off experimentation and development of innovative
products and services.
Laws can, however, help to assure that investors have adequate information presented in accurate form so that they, the investors, can make an intelligent assessment of
the risks involved and can decide which risks they are willing to take. Laws also can assure
that remedies are available to investors in the event of fraud or unfair dealings. For these
reasons, under the laws in the majority of the world's market economies, the basis for
providing protections for investors and promoting market efficiency is full and fair
disclosure of critical information about the companies that issue the securities traded and
transparency in the market itself.
Since information is of the essence of the market mechanism, relying upon disclosure as the mainstay of the regulatory system harmonizes with the objectives of
regulation and minimizes the interference with market forces. It is axiomatic that a "perfect
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market entails perfect information". The investor is offered the protection of adequate and
accurate information, but the investment decision and the investment risks are his/hers.
For a disclosure system to work, the form and content of disclosure must be standardized and the making of appropriate disclosure must be supervised and monitored by
a public agency. Securities laws achieve these objectives by establishing prospectus
requirements, accounting standards and requirements for periodic reports.
The company managers charged with the responsibility to make disclosure perforce
must develop adequate information systems to generate the information and data to be
reported. A useful by-product, therefore, is the development of more sophisticated
management information systems that serve as a vital management tool as much as a means
of complying with disclosure requirements.
Laws governing the capital market are also concerned with assuring the competence
and reliability of the professionals who serve public investors. Moreover, since investors
would not readily be persuaded to buy shares if they did not believe they could sell them if
necessary, or if they wanted to take a profit or reduce a loss, the viability of the markets in which securities are traded also is an important aspect of investor protection. Finally, it is one thing to pronounce standards and requirements and another to make sure that they are
followed. Accordingly, the means available for enforcement of the requirements and
standards set is a vital aspect of investor protections in the capital markets.
Whatever information is required to be disclosed must be analyzed and interpreted.
In the first instance, this can be expected to be done by professionals in the financial
institutions, but the advantages of increased information and of the skill effectively to use it for analysis and decision-making can be expected to be availed by others in time. Individual
investors can educate themselves to utilize the available information; professional advisers
can come into service to counsel investors.
A broad-based capital market depends on reliable and knowledgeable professional
intermediaries to serve both the demand and supply sides of the market. Even sophisticated
members of the public may require help from professional analysts and advisers when it
comes to matters related to investment in shares. Shares are complicated property interests. To evaluate complex financial information, even in the most expansive formats, requires
special understanding and skill. Accordingly, it is critically important to the development of a broad-based capital market that investors have resort to professionals who have the
capacity and skill to understand share investment, to evaluate company performance, to
analyze financial data and to interpret all of this for public investors.
In addition, investments in shares need to be marketed as a concept and as specific
opportunities. A Wall Street adage is that "shares are sold, not bought", which means that
investors must be persuaded to undertake share investments. Enterprising brokers are
inevitably a mainstay of any promotional effort. Of course enterprising zeal must be
accompanied with accountability to prevent abusive practices.
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