This paper investigates the impact of investor protection legislation on foreign shareholders and bondholders. We find, not surprisingly, a positive "direct" effect of investor protection laws: foreign stock and bond investments are encouraged by legislation that better protects, respectively, shareholder and creditor rights. However, different investor classes are endowed with different rights, and conflicting interests among them can make strong protections afforded to one party detrimental to another. Indeed, we find that investor protection laws have significant and sizeable "cross" effects on foreign portfolio investment and that the direction of these effects is fully consistent with the conjecture that foreign stakeholders are relatively more sensitive to the perceived riskiness of assets than domestic investors. Specifically, we find that strong protection of creditor rights -- limiting excessive risk taking -- positively affects foreign shareholders, whereas strong protection of shareholder rights -- potentially shifting a firm toward riskier projects -- has a negative impact on foreign bondholders. The immediate policy implication of our findings is that strengthening investor protection rights is not a universally desirable policy. More specifically, accounting for the interaction of conflicting corporate governance mechanisms is critical to the design of regulatory policies and strategies aimed toward enhancement of inward foreign investment.
