TWO ESSAYS IN CORPORATE FINANCE DISSERTATION. The Ohio State University. Dong Wook Lee, M.B.A. The Ohio State University

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1 TWO ESSAYS IN CORPORATE FINANCE DISSERTATION Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Dong Wook Lee, M.B.A. The Ohio State University 2003 Dissertation Committee: Approved by Professor René M. Stulz, Advisor Professor G. Andrew Karolyi Professor Ingrid M. Werner Advisor Graduate Program in Business Administration

2 Copyright by Dong Wook Lee 2003

3 ABSTRACT This dissertation studies two recent phenomena in corporate finance. The first is that a number of non-u.s. firms list their shares in the U.S. stock markets, and the second is that equitybased compensation schemes such as employee stock options are widely used in many U.S. corporations. The first essay builds on existing empirical evidence showing that foreign firms experience a positive abnormal stock return when they announce they will list in the U.S. This essay shows that the announcement return is largely unrelated to the degree of integration between the local stock market and the U.S. stock market and that the announcement of crosslisting in the U.S. is associated with negative abnormal returns for competitors of the announcing firm. Further, competitors with higher agency costs of controlling shareholders are more negatively affected. These results suggest that foreign firms list in the U.S. to improve their ability to take advantage of growth opportunities and not to reduce the equity risk premium. The second essay examines whether management, when its personal wealth associated with its stock options is at stake, takes opportunistic actions by manipulating the stock price. Using a unique experimental setting created by an accounting rule, this essay provides some evidence supportive of the manipulation hypothesis. Further, it seems that this manipulation is costly to shareholders as some shareholders have to trade while the deviation remains uncorrected. ii

4 To Ok Joo Lee iii

5 ACKNOWLEDGMENTS I would like to thank my advisor, René Stulz, for his support and guidance. I especially thank him for his patience with my struggles and mistakes towards this dissertation and for being an academic example to me. I would also like to thank my committee members, Andrew Karolyi and Ingrid Werner, for their guidance. They have always been generous with their time and comments that helped make this dissertation possible. I am deeply thankful to my family for their love and support. My parents had to put up with me not available while I was working on my doctoral degree. I am grateful to them for their support. My deepest thank goes to my wife, Ok Joo Lee, who always stands by me with unconditional love. Ever since I started thinking of pursuing an academic career, Ok Joo, as a girlfriend, then a fiancé, and finally a wife, had to deal with as many burdens as I did. I am glad that I have many days ahead with her to make up for her sacrifice. This dissertation has benefited from comments at various seminars. I am especially grateful to Bill Francis, Bing Han, Jean Helwege, David Hirshleifer, Brad Jordan, Susan Jordan, Sonya Seongyeon Lim, Bernadette Minton, Joe Peek, and John Puthenpurackal for helpful comments and suggestions. iv

6 VITA January 28, Born Seoul, Korea Bachelor of Business Administration, Seoul National University Master of Business Administration, Seoul National University PUBLICATIONS Kho, B.-C., D. Lee, and R. Stulz, 2000, U.S. Banks, crises and bailouts: From Mexico to LTCM, American Economic Review Papers and Proceedings FIELDS OF STUDY Major Field: Business Administration Concentration: Finance v

7 TABLE OF CONTENTS ABSTRACT...ii ACKNOWLEDGMENTS... iv VITA... v LIST OF TABLES... ix LIST OF FIGURES... x CHAPTER 1: Introduction... 1 CHAPTER 2: Why does shareholder wealth increase when foreign firms announce their listing in the U.S.? Introduction Information contents of the announcement of cross-listing in the U.S Theories of a reduction in the equity risk premium Theories of an improvement in the ability to take advantage of growth opportunities The risk premium benefit vs. the growth opportunities benefit: Testing hypotheses...11 vi

8 The risk premium benefit vs. the growth opportunities benefit: A graphical analysis Data and methodology Empirical results The abnormal returns for the announcing firm and for other firms in the same country The announcement abnormal return and the degree of financial market integration Firm-level analysis: the risk premium benefit vs. the growth opportunities benefit Further cross-section of other firms in the country: are there any other ffects? Robustness check: the role of return correlation in earlier events Conclusion CHAPTER 3: Do managers manipulate the stock price to have a lower exercise price for their stock options? Introduction Accounting treatment of stock options and the option exchange program Accounting treatment of stock options The stock option exchange program Testing hypotheses Data and methodology Data Empirical methodology Empirical results Abnormal stock returns during, after, and before the waiting period vii

9 Does management simply know more? More direct evidence of opportunistic timing of news announcements How does the stock market react to the announcement of the exchange program? Conclusion CHAPTER 4: Conclusion LIST OF REFERENCES APPENDIX A APPENDIX B viii

10 LIST OF TABLES Table 1: Frequency distribution of the sample of U.S. exchange cross-listings by emerging market firms Table 2: The cumulative abnormal returns associated with the sample U.S. exchange cross-listing announcements Table 3: Regressions of the 7-day cumulative abnormal returns for announcing firms on the integration proxy and control variables Table 4: Regressions of the 7-day cumulative abnormal returns for other firms in the same country as the announcing firm on their firm characteristics Table 5: Regressions of the 7-day cumulative abnormal returns for other firms in the same country as the announcing firm on their firm characteristics Table 6: Frequency distribution of the sample firms Table 7: The mean daily abnormal returns for the sample firms Table 8: The mean daily abnormal return during the waiting period - Management's participation vs. Overall participation rate Table 9: Analysts' forecast errors for quarterly earnings: the waiting period vs. benchmark period Table 10: CARs associated with the announcement of the option exchange program Table 11: Cross-sectional regressions of the CARs on firm characteristics Table 12: Corrections of original datasets ix

11 LIST OF FIGURES Figure 1. A firm s cost of funds for a project Figure 2. The effect of the risk premium benefit Figure 3. The effect of the growth opportunities benefit Figure 4. 7-day abnormal returns for levels II or III ADR announcing firms over global financial markets integration Figure 5. 7-day abnormal returns for levels II or III ADR announcing firms over global financial markets integration x

12 CHAPTER 1 INTRODUCTION This dissertation studies two recent phenomena in corporate finance. The first is that a number of non-u.s. firms list their shares in the U.S. stock markets, and the second is that equitybased compensation schemes such as employee stock options are widely used in many U.S. corporations. The first essay provides empirical results that can distinguish between existing theories for the incentives of non-u.s. firms to list in the U.S. The second essay examines whether management, when its personal wealth associated with stock options is at stake, takes opportunistic actions at the cost of shareholder wealth. The first essay, presented in Chapter 2, builds on existing empirical evidence showing that foreign firms experience a positive abnormal return when they announce they will list in the U.S. There are two competing explanations for this result. The first explanation is that crosslisting in the U.S. reduces the risk premium on a firm s stock by reducing the barriers to investing in the stock for U.S. investors. The second explanation is that cross-listing in the U.S. improves a firm's ability to take advantage of its growth opportunities by enhancing the protection of minority shareholders and, thus, making it easier for the firm to access external finance. This essay attempts to determine the relative importance of the two benefits, as they imply different economic consequences of cross-listing in the U.S. First, the risk premium benefit will accrue to other firms in the same country as well as to a cross-listing firm itself because the 1

13 cross-listed stock introduces U.S. factors into the price of other local stocks and thus lowers their risk premium. In particular, firms with a higher return correlation with the cross-listing firm will benefit more from the indirect risk premium effect. On the other hand, the growth opportunities benefit, as a firm-specific event, would rather put other firms at a competitive disadvantage with little spillover benefit. Moreover, the risk premium benefit is relevant to the extent that cross-listing in the U.S. reduces investment barriers to investing in the cross-listed stock for U.S. investors. Therefore, the benefit should become marginal as the local stock market becomes integrated with the U.S. stock market and fewer investment restrictions are left to be mitigated by cross-listing. It follows from that that fewer foreign firms will list in the U.S. over time if the risk premium benefit is the only benefit. On the other hand, the growth opportunities benefit is unrelated to the degree of financial integration of a local market with the U.S. market, so foreign firms would not become less likely to list in the U.S. over time. With a sample of emerging market firms, I find the announcement abnormal return is largely unrelated to the degree of integration between the local stock market and the U.S. stock market. I also find that the announcement of cross-listing in the U.S. is associated with negative abnormal returns for competitors of the announcing firm and, further, competitors with higher agency costs of controlling shareholders are more negatively affected. I therefore conclude that most of the announcement abnormal return is due to an improvement in the firm's ability to take advantage of growth opportunities and not to a reduction in the equity risk premium. The second essay is presented in Chapter 3. This essay investigates a unique period of at least six months and one day, at the beginning of which a company cancels employee stock options that are voluntarily tendered in return for replacement options to be granted at the end of the period. As the exercise price of the replacement options is determined by the stock price on the grant date, a decrease in the stock price during the period benefits participating employees. 2

14 Using this experimental setting, I examine the hypothesis that management, when its options are tendered in exchange for replacement options, manipulates the stock price during the period through opportunistic timing of news announcements to have a lower exercise price for the replacement options. It is shown that firms in which management participates in the exchange program experience a significant negative abnormal return during the waiting period but not afterwards. It is also shown that, for firms in which management participates in the exchange program, analysts' earnings forecasts are more pessimistic during the waiting period than earnings forecasts at other times. In others firms in which management does not participate in the exchange program, I do not observe such an abnormal return or earnings forecast pattern. However, there is no difference between the two groups of firms either in the abnormal return or in the earnings forecasts. Further, firms announcing an exchange program in which management can participate experience a more negative abnormal return than other firms whose exchange program excludes management from the outset. The abnormal stock return and analysts' forecast results lend some support to the manipulation hypothesis that management manipulates the stock price by accelerating announcements of bad news during the waiting period and deferring announcements of good news until after the waiting period. The announcement return results then suggest that this manipulation is costly to shareholders as some shareholders are short-term investors and have to trade towards the end of the waiting period. 3

15 CHAPTER 2 WHY DOES SHAREHOLDER WEALTH INCREASE WHEN FOREIGN FIRMS ANNOUNCE THEIR LISTING IN THE U.S.? 2.1. Introduction. Why do foreign firms list in the U.S? Prior studies have documented a significant positive abnormal stock return for firms announcing their listing in the U.S. (Foerster and Karolyi (1999) and Miller (1999)). A number of theories have been proposed to explain this announcement return, or equivalently, benefits from cross-listing in the U.S., 1 and they can be categorized into two groups by the source of gains on which those theories build. One set of theories, based on the international asset pricing models, argues that firms increase their value by cross-listing in the U.S. because their risks become shared across more investors. It follows from this that the announcement of cross-listing in the U.S. will create an expectation of more risksharing between local and U.S. investors for the cross-listed stock and therefore reduce its risk 1 There are other studies that examine other aspects of benefits from cross-listing in the U.S. For example, Baker, Nofsinger, and Weaver (2003) document an increase in media coverage and analyst following; Lang, Lins, and Miller (2002) show an increase in analyst following and its positive relation with firm value; Foerster and Karolyi (1999) show a price run-up before the listing; Doidge, Karolyi, and Stulz (2003) document higher firm value for cross-listing firms; Lins, Strickland, and Zenner (2000) find less sensitive corporate investment to cash flows after cross-listing; and Reese and Weisbach (2002) show more equity capital raising after cross-listing. However, all of them are subject to causality problem: we do not know whether cross-listing in the U.S. benefits firms or well-performing firms tend to cross-list in the U.S. 4

16 premium (Stapleton and Subrahmanyam (1977), Alexander, Eun, and Janakiramanan (1987), and Foerster and Karolyi (1999)). Another set of theories, based on differential investor protection across countries, views cross-listing in the U.S. as a bonding activity. By voluntarily subjecting themselves to better protection of minority shareholders (i.e., U.S. regulatory and informational environments) at the cost of private control benefits to controlling shareholders, cross-listing firms can facilitate their access to outside capital markets and, thus, improve their ability to take advantage of growth opportunities. 2 Therefore, the announcement of cross-listing in the U.S. confirms growth opportunities whose payoffs to controlling shareholders will more than offset their loss of private benefits of control, leading to an increase in future cash flows due to more investments and less expropriation (Coffee (1999, 2002), Stulz (1999a), Reese and Weisbach (2002), and Doidge, Karolyi, and Stulz (2003)). The two benefits, however, imply different economic consequences of cross-listing in the U.S., and it is crucial to determine the relative importance of the two benefits in the announcement return to better understand why foreign firms list in the U.S. First, the risk premium benefit will accrue to other firms in the same country as well as to a cross-listing firm itself because the cross-listed stock introduces U.S. factors into the price of other local stocks and thus lowers their risk premium. In particular, firms with a higher return correlation with the crosslisting firm will benefit more from the indirect risk premium effect. On the other hand, the growth opportunities benefit, as a firm-specific event, would rather put other firms at a competitive disadvantage with little spillover benefit. Moreover, the risk premium benefit is relevant to the extent that cross-listing in the U.S. reduces investment barriers to investing in the cross-listed stock for U.S. investors. Therefore, the 5

17 benefit should become marginal as the local stock market becomes integrated with the U.S. stock market and fewer investment restrictions are left to be mitigated by cross-listing. It follows from that that fewer foreign firms will list in the U.S. over time if the risk premium benefit is the only benefit. On the other hand, the growth opportunities benefit is unrelated to the degree of financial integration of a local market with the U.S. market, so foreign firms would not become less likely to list in the U.S. over time. With a sample of emerging market firms, we find that a firm's announcement of its listing on a U.S. exchange is associated with a significant negative abnormal return for the portfolio of domestic industry competitors. However, other firms in the same country but from different industries are hardly affected. The experience of domestic industry competitors is instructive, as they are in a better position to share the risk premium benefit due to their higher return correlation with the announcing firm, and, at the same time, they compete with the announcing firm. The significant negative abnormal return on the portfolio of industry competitors suggests that the announcement has more information about the announcing firm s ability to take advantage of its growth opportunities than about the firm's equity risk premium. We also find that the abnormal return for firms announcing their listing on a U.S. exchange is largely unrelated to the degree of financial market integration between the local and the U.S. stock markets in the sense that the announcement return does not decrease with the number of ADR programs from the same country: some announcing firms still experience a significant positive abnormal return with almost 100 previous ADR programs from the same country. This result does not change with alternative proxies for integration such as aggregate U.S. ownership for the local stock market, and is robust to controlling for other factors such as anticipation of the announcement. 2 Of course, the incentive to cross-list in the U.S. will be valid only when those growth opportunities cannot 6

18 We then conduct a firm-level analysis to further assess the relative importance of the two benefits. Theories of better ability to take advantage of growth opportunities imply that, among domestic industry competitors, firms with more agency problems are more negatively affected because they would lose more business and financial opportunities to the cross-listing firm: the benefit to a cross-listing firm is a cost to the firm s competitors, and this cost is more important for firms with higher agency costs as the benefit to the cross-listing firm is a reduction in its agency costs. Theories that emphasize the reduction in the risk premium, on the other hand, have an explicit prediction that the indirect risk premium benefit accruing to other firms in the same country as a cross-listing firm is an increasing function of a firm's return correlation with the cross-listing firm. Following Stulz (1990), we proxy for agency costs of controlling shareholders by growth opportunities (Tobin's q ratio) 3 and find that the abnormal returns of domestic industry competitors are positively related to their Tobin s q ratio. Specifically, the abnormal returns for high-q (above-one or above-industry median) competitors are significantly larger than the abnormal returns for low-q competitors. This result is consistent with the hypothesis that crosslisting firms reduce the agency costs of controlling shareholders and exploit more growth opportunities on better financing terms, so that competitors with more agency problems are more adversely affected. After controlling for this industry competitive effect, a firm's return correlation with a cross-listing firm, however, does not explain its abnormal return associated with the announcement of the cross-listing firm. be financed internally or with riskless debt. 3 This, in effect, needs two steps. Stulz's (1990) argument is originally for managerial discretion. Then, La Porta, Lopez-De-Silanes, and Shleifer (1999) show that, except for U.S. and U.K. firms, the control of a firm's resources is in the hands of its controlling shareholders. 7

19 Based on our findings, we conclude that most of the abnormal returns for firms that announce their listing in the U.S. are due to an improvement in the ability to take advantage of growth opportunities and not to a reduction in the equity risk premium. This paper proceeds as follows. In Section 2.2, we review theories for cross-listing in the U.S. in our dichotomous categorization, focusing on their implication for the announcement return. We present our data and methodology in Section 2.3. Our empirical results are in Section 2.4. Finally, we provide conclusions in Section Information contents of the announcement of cross-listing in the U.S. In this section, we briefly review existing theories for cross-listings in the U.S. and then explain the tests we use to distinguish between these theories. We also provide a graphical analysis as a supplementary exposition of our testing hypotheses. Cross-listing in the U.S. and ADR programs are interchangeable in the following discussion Theories of a reduction in the equity risk premium Cross-listing in the U.S. originally has been given attention as a way to overcome international financial markets segmentation. Although foreign ownership limits are not overruled, cross-listed stocks (as a form of ADRs, global shares, or ordinary shares) are quoted and traded in U.S. dollars in the U.S. trading system, and dividends are paid in U.S. dollars. These lowered investment barriers facilitate U.S. investors' holding of foreign stocks, so that their 4 Cross-listing in the U.S. is done mostly by establishing an ADR program. Technical difficulties with cross-border clearing and settlement have necessitated an intermediate vehicle like ADR program. Without such problems, foreign firms would prefer to directly use their local shares like Canadian firms. The difference between an ADR program and direct listing is insignificant and not relevant to our study, so the two terms are interchangeable in our paper. There are four types of ADR programs. Levels II and III ADRs are traded on a stock exchange, level I ADRs are traded on the over-the-counter (OTC) market, and 144A ADRs are traded among large institutional investors in the PORTAL market. Level III and 144A ADRs entail capital-raising as well, the former publicly and the latter privately. See, for example, Coffee (1999) and Reese and Weisbach (2002) for institutional details. 8

20 risks can be shared across more investors (the market segmentation hypothesis by Stapleton and Subrahmanyam (1977) and Alexander, Eun, and Janakiramanan (1987)). Probably more importantly, foreign firms provide U.S. investors with more information after listing in the U.S., either through their required filings with the SEC or by outside financial institutions' following (e.g., analysts, auditors). Listing in the U.S. will therefore enhance a foreign firm s recognition and visibility to U.S. investors, making it more likely for U.S. investors to hold the firm s stock (the recognition hypothesis by Foerster and Karolyi (1999)). According to this set of theories, a foreign firm's announcement of its listing in the U.S. will create an expectation of more risk-sharing between local and U.S. investors for its stock and therefore reduce the equity risk premium, leading to a positive abnormal return. As the benefit is relevant to the extent that foreign investment barriers are lowered, the announcement return will have a positive relation to the magnitude of foreign investment restrictions mitigated by crosslisting in the U.S Theories of an improvement in the ability to take advantage of growth opportunities This set of theories has developed as an alternative to the traditional risk premium approach, providing more of a corporate finance explanation based on differential investor protection across countries (La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998, 2000); LLSV, hereafter). It focuses attention on the fact that cross-listing firms become subject to U.S. legal and informational environments that arguably make it more difficult and expensive for controlling shareholders of cross-listing firms to expropriate minority shareholders. 5 A foreign 5 For details of changes in regulatory environments associated with cross-listing in the U.S., see, for example, Coffee (1999, 2002), Reese and Weisbach (2002), or Doidge, Karolyi, and Stulz (2003). There is a debate about whether the U.S. legal enforcement is strong enough to enhance a foreign firm's corporate 9

21 firm s voluntary decision to list in the U.S. can therefore be seen as a bonding activity. By voluntarily subjecting themselves to better protection of minority shareholders (i.e., U.S. regulatory and informational environments), cross-listing firms can facilitate their access to outside capital markets and, thus, improve their ability to take advantage of growth opportunities (Coffee (1999, 2002), Stulz (1999a), Reese and Weisbach (2002), and Doidge, Karolyi, and Stulz (2003)). The empirical prediction for the announcement return, however, needs another logical step. From the perspective of controlling shareholders, the improved ability to take advantage of growth opportunities comes at a cost: controlling shareholders should lose some of their private control benefits as a result of more stringent corporate governance. In other words, there is a tradeoff associated with cross-listing in the U.S., and the decision to cross-list in the U.S. implies a change in this tradeoff: the decision will not be made unless there are growth opportunities that need external finance and whose payoffs more than offset the loss of private control benefits. The announcement of cross-listing in the U.S. thus reveals the existence of such growth opportunities within the announcing firm, and the stock price will increase in anticipation of more profitable governance. With a sample of Mexican firms, Siegel (2002) documents that the SEC s enforcement efforts are rare, and argues that cross-listing firms are not necessarily less likely to experience expropriation; rather, cross-listing firms seem more likely to get involved in expropriation. Siegel (2002) instead finds that the U.S. financial markets discipline foreign firms: cross-listing firms that were not engaged in expropriation are more likely to receive outside capital whereas other cross-listing firms that did expropriate are not able to raise capital. Siegel then argues that the reputational bonding is more important and effective than the legal bonding. His argument and empirical findings are in fact supportive of the growth opportunities explanation. The issue is whether U.S. corporate environments can reduce agency costs of controlling shareholders; Siegel (2002) is saying yes to this question. The entire debate boils down to the question of whether contracts can be perfectly enforced among participating individuals at the market or a regulatory regime such as legal enforcement is needed, which is always an empirical question. Siegel's (2002) findings are contrary to the legal hypothesis but still consistent with the growth opportunities explanation. 10

22 investments and less expropriation. The announcement return will have a positive relation to the improvement in corporate governance due to cross-listing in the U.S The risk premium benefit vs. the growth opportunities benefit: Testing hypotheses To derive our testing hypotheses, we begin with previous studies and their limitations. In support of the risk premium benefit, Miller (1999) finds a larger announcement return for firms from emerging markets than ones from developed markets, and a larger announcement return for firms listing on an exchange (level II or III ADR programs) than other firms listing on OTC or PORTAL markets (level I and 144A ADR programs, respectively). These findings are, however, consistent with the growth opportunities benefit as well. The difficulty stems from the fact that the proxies for the risk premium benefit (i.e., the magnitude of investment restrictions mitigated by cross-listing) are correlated with the growth opportunities benefits (i.e., the improvement in corporate governance by cross-listing). Compared to developed markets, emerging markets have more foreign investment restrictions at work, but, at the same time, their investor protection is poorer. Similarly, ADRs traded on the OTC or PORTAL markets are, compared to level II or III ADRs traded on an exchange, less visible and thus less likely to be held by U.S. investors. However, it is also true that changes in regulatory and informational environments associated with OTC- or PORTAL-listed ADRs are minimal. 6 The signaling hypothesis modeled by Fuerst (1998) and Moel (1999) is subsumed into theories of growth opportunities benefit, as it is based on changes in legal and informational environments associated with cross-listing in the U.S. However, it is not explicit about the source of benefits and says only that the signal is so costly that, assuming the decision was well made, there must be something good enough to overcome the costs. The liquidity hypothesis by Lins, Strickland, and Zenner (2000) can be seen as a stepping-stone between the risk premium explanation and the growth opportunities explanation. Different from the growth opportunities explanation where the main issue is the improvement in a cross-listing firm's general ability to finance externally, the authors focus attention on the enhanced access to U.S. capital markets due to a cross-listing firm's presence in the U.S. and better communication with U.S. investors in their language ( reduced information asymmetry between a cross-listing firm and U.S. investors in their own words). 11

23 Our strategy is to shy away from the cross-country or cross-adr type differences to avoid their indeterminate inference. Instead, with relatively homogeneous originating countries and types of ADR programs, we turn our attention to other firms in the same country as a crosslisting firm, for which the two benefits have different implications. The risk premium benefit is an asset-pricing event and should affect all other stocks in the same pricing setting. Specifically, as a cross-listed stock is included in the local market portfolio, its reduced risk premium should lower the risk premium for the local market portfolio. As a consequence, changes in the local market risk premium would affect all other local stocks that are priced relative to the local market portfolio. H1. If the risk premium benefit is material, other firms in the same country as the announcing firm should experience a positive abnormal return. The growth opportunities benefit does not have an empirical implication for those other firms as a whole. We then examine a subset of nonevent firms in the country. The indirect risk premium benefit accruing to other firms in the same country as a cross-listing firm is a function of their return correlation with the cross-listing firm. Otherwise, firms with similar risk characteristics would have different expected returns (Alexander, Eun, and Janakiramanan (1987) and Eun, Classens, and Jun (1995)). The growth opportunities benefit, on the other hand, is a firm-specific event and will not bring about any spillover benefit. Rather, it will put other firms at a competitive disadvantage. Industry competitors of a cross-listing firm turn out to be instructive, as they are highly correlated with the cross-listing firm, and, at the same time, they are competing with the cross-listing firm. 12

24 H2. If the risk premium benefit is dominant in a firm s announcement of listing in the U.S., industry competitors of the announcing firm should experience a positive abnormal return. If the growth opportunities benefit is dominant in the announcement, industry competitors should experience a negative abnormal return. As for abnormal returns accruing to an announcing firm itself, we examine their timeseries patterns due to our focus on homogeneous types of ADR programs from homogeneous home countries. 7 We have seen that the risk premium benefit is relevant only to the extent that cross-listing in the U.S. overcomes investment barriers to global risk-sharing. As a local market becomes more integrated with the U.S. stock market through a variety of channels, more local stocks will be included in the investment opportunity set of U.S. investors, or at least, more of them can be mimicked by other local stocks in which U.S. investors can invest. H3. If the risk premium benefit alone accounts for abnormal returns accruing to firms that announce their listing in the U.S., the announcement return should decrease with degree of financial integration between the local and the U.S. markets. The growth opportunities benefit, however, is unrelated to the degree of financial integration. Looking at nonevent firms in a country indiscriminately could understate the possibility that they are affected by the announcement of a cross-listing firm with a varying degree. 7 As explained later in more detail, we examine emerging market firms only. Having both emerging markets and developed markets in a common sample period would make this analysis difficult. Developed markets in, say, the 1990s are already globally integrated as shown by, for example, Errunza, Hogan, and Hung (1999), so that it is impossible to examine how the announcement return changes as the local market becomes globally integrated. We would face a similar problem with emerging markets if we used the sample period of, say, the 1980s or earlier when most emerging markets were closed to the rest of the world and level II or III ADR programs were a rarity. 13

25 Therefore, we need a firm-level testing hypothesis. The indirect risk premium benefit to nonevent firms in the country is an increasing function of their return correlation with the announcing firm, whereas the competitive effect from the growth opportunities benefit is related to a competitor's agency problems. It is because the benefit to a cross-listing firm should be a cost to the firm s competitors. This cost will be more important for firms with higher agency costs as the benefit to the cross-listing firm is a reduction in its agency costs. H4. If the risk premium benefit is material, firms in the same country with a higher return correlation with the announcing firm will experience a more positive abnormal return than other firms. If the growth opportunities benefit is material, industry competitors with more agency problems will experience a more negative abnormal return The risk premium benefit vs. the growth opportunities benefit: A graphical analysis The risk premium benefit and the growth opportunities benefit could sound as if they were two faces of the same coin; they could simply be describing the same benefit of a reduction in a firm's cost of capital from a different angle. Below we elaborate on distinctions between the two benefits and reinforce our testing hypotheses derived earlier. We start with Figure 1 showing a firm's cost of funds for a certain project whose risk characteristics are similar to those of existing projects within the firm. 8 Without any market frictions (e.g., enough internal funds or the ability to issue riskless debt), a firm's cost of funds for a project would be the required rate of return based on its equity risk premium. However, as the firm faces more market frictions, the cost of funds will go up. Hidden action and hidden 14

26 information between the firm and outside capital markets will bring about agency problems and information asymmetries, and outside capital providers can no longer expect to be properly protected and receive all cash flows from the project. To guarantee that investors will receive the same amount of cash flows as they would without any expropriation, the firm has to expend additional resources on otherwise unnecessary items such as costly contracts or subsequent monitoring activities. In other words, when new funds are raised externally, outside capital providers expect the same rate of return based on risk characteristics of the project (i.e., the equity risk premium), but, due to deadweight costs associated with the new funds, the firm faces a higher cost of funds. Figures 2 and 3 show how a cross-listing in the U.S. affects the listing firm's cost of funds under the scenarios of the risk premium benefit and of the growth opportunities benefit, respectively. The risk premium benefit is a reduction in a firm's systematic risk, so the entire costs of funds curve shifts downwards. The magnitude of this shift then depends on the degree of financial integration between the local and the U.S. markets. The growth opportunities benefit, on the other hand, is a reduction in deadweight costs associated with external finance, so it only affects the upward-sloping part of the curve with the same base flat line. This effect therefore has nothing to do with the degree of financial integration between the local and the U.S. markets (H3). A reduction in a cross-listing firm's systematic risk will benefit other firms, as it will affect the risk of the local market portfolio and consequently the risk of other stocks relative to the local market portfolio. However, a reduction in a cross-listing firm's deadweight costs associated with external finance will hardly benefit other firms, as the effect is firm-specific (H1). Rather, the growth opportunities benefit will cause a negative competitive effect: a cross-listing 8 Fazzari, Hubbard, and Petersen (1988) and Hubbard later (1998) use a similar graph using a firm's internal 15

27 firm can raise external funds at a cheaper cost and become better able to take advantage of its growth opportunities. This puts other firms at a competitive disadvantage (H2), and among competitors, those with more such deadweight costs will experience more competitive pressure (H4). A reduced systematic risk due to the risk premium benefit could make some projects within a firm more profitable, leading to more investments. However, as in Figure 1.B, the risk premium benefit is relevant even to firms without any growth opportunities. Firms can be motivated to cross-list in the U.S. because better risk-sharing between local and U.S. investors can make their shares more valuable. As a consequence, according to the risk premium explanation, the announcement of cross-listing in the U.S. has no information about the announcing firm's growth opportunities and thus is unlikely to create a competitive effect (H2). It is also important to note that a firm s ability to take advantage of its growth opportunities is related to the magnitude of deadweight costs associated with external finance, or the "wedge" between a firm's actual cost of funds for a project and the rate of return required by outside investors. This stands for how likely a firm is to forgo profitable growth opportunities: a project may have positive net present values at a discount rate based on its risk characteristics, but significant deadweight costs associated with funding it externally could make the project less profitable. The growth opportunities benefit makes a cross-listing firm better able to take advantage of its growth opportunities by reducing this wedge; the risk premium benefit, however, does not make any changes to this wedge, leaving the company equally likely to forgo profitable projects (H2). funds as the x-axis. Stulz (2000) has a similar analysis to ours at the country level. 16

28 2.3. Data and methodology We construct our sample by focusing on firms launching a level II or III ADR program and originating from emerging markets. As discussed in Section 2.2, this enables us to bypass difficulties in previous studies, namely cross-country and cross-adr type differences are consistent with both the risk premium benefit and the growth opportunities benefit. At the same time, we include other firms in the same country as an ADR-issuing firm in our sample, so that we utilize different empirical implications of the two benefits for those nonevent firms. Specifically, we start with firms in Latin American or Asian emerging markets with exchange-listed ADR programs up to September This information is collected from the union of the Bank of New York ADR database and the Citibank ADR database. After deleting duplicate records for a firm (e.g., subsequent ADR programs), we obtain 155 firms from 13 countries. Malaysia, Pakistan, Sri Lanka, and Thailand have no exchange-listed ADR program. Of the 155 cross-listing firms, we are able to find the announcement date for 134 firms. 9 We also require those firms to have stock price data in Datastream at about the time of their announcement date. After this screen, we end up with 69 firms; we lost all Chinese firms since all 9 Announcement dates are from a Lexis/Nexis keyword search on The World and The Wire databases. Keywords include: depositary, ADR, GDR, SEC, Securities and Exchange Commission, and list or offer - one at a time - along with company name. We define the earliest press date with material information about cross-listing as the announcement date. Therefore, articles saying "...will list in the U.S. in the next 18 to 24 months..." are dropped and the next earliest article with more specific information is chosen. We double-check the dates with The Wall Street Journal Index. When The Wall Street Journal has an earlier date, we use the WSJ date. Our announcement dates precede the listing date, on average, by 138 days (the median difference is 30 days). Among the 69 sample announcements, seven announcements precede the listing date by more than a year. Excluding them, the mean difference is 66 days and the median is 28 days. We double-checked those seven announcements and were convinced that they are all valid event dates. The largest difference is 1,625 days for a Brazilian company, Sadia (Datastream code: ). Originally, markets learned its intention to offer shares in the U.S. stock market on October 28, 1996, but the actual listing happened on April 10, In the intervening time, there was an acquisition of another company, and the listing was accordingly delayed. The next earliest press release (on November 8, 2000) says "... Processed food company Sadia is expected to issue Level-II American Depositary Receipts (ADRs) before the end of the year, said Sadia board chairman Luis Fernando Furlan. The issue has been ready for some time, but since Sadia purchased Granja Rezende, the US Securities & Exchange Commission (SEC) made fresh requirements..." Miller's (1999) sample has an average 77 days between the listing date and the announcement date. 17

29 of them are IPOs and, thus, their stock price data is not available around the announcement date. Table 1 provides information about the distribution of the 69 sample announcing firms by country, year, and industry. For each of the announcing firms, we collect information about other firms in the same country. Specifically, we include all domestic firms in Emerging Market DataBase (EMDB; formerly International Financial Corporation or IFC) Global Index to which each of the announcing firms belongs. If any of those nonevent firms also has an exchange-listed ADR program and its announcement date is as close as up to one week to the announcement date of the corresponding announcing firm, we disqualify that firm from the nonevent firms. Their stock price data are also from Datastream, and their accounting data are from Worldscope. Of them, industry competitors are defined as firms with the same Datastream level-4 industry classification as the announcing firm. This classification is similar to 2-digit SIC code. Our empirical analysis is then conducted with abnormal returns for the announcing firms and for the other firms in the same country as the announcing firms. We examine both 3-day abnormal return over (-1, 1) window and 7-day abnormal return over (-5, 1) window relative to the announcement date, estimated from the OLS market model over the period of (-250, -26) relative to the announcement date with a minimum of 100 observations. The most common window used in an event study is (-1, 0). With foreign data for countries in a different time zone, however, (-1, 1) would be more appropriate since what happens on a day in, for example, Korea would be in U.S. newspapers on the previous day. By examining the longer window of (-5, 1), we take into account possible information leakage. We made two corrections on our original dataset. First, we corrected the announcing firm's Datastream industry classification (level 4) if it was different from the two ADR databases' industry information or it was "Diversified Industrials", in which case we determined the industry by consulting with EMDB and Moody's International database. The details are provided in the 18

30 Appendix. Another correction was in the stock price data for two firms on two dates - one for each firm. One Brazilian and one Peruvian telecommunication company each experienced a huge change in their Datastream return index (price level) on a certain date, but their market value showed a different movement. We treated the return on that date as missing. This information also appears in the Appendix Empirical results We present our empirical results in stages. First, we report abnormal returns for the announcing firm and for the portfolio of other firms in the same country as the announcing firm. Second, we present the relation between the announcing firm's abnormal return and the degree of capital markets integration of its home country with the U.S. stock market. Third, we examine individual abnormal returns for other firms in the same country The abnormal returns for the announcing firm and for other firms in the same country In this section, we test our first and second testing hypotheses. According to the risk premium explanation, when a firm announces its listing in the U.S., other firms in the same country should have a positive abnormal return because of a reduction in the local market risk premium driven by a reduction in the announcing firm s risk premium. Further, firms in the same industry, due to their higher return correlation with the announcing firm, should have a more positive abnormal return than other firms from different industries. However, the growth opportunities explanation predicts that firms in the same industry will be negatively affected, as they will be put at a competitive disadvantage by an improvement in the announcing firm s ability to take advantage of its growth opportunities. For other firms from different industries, the growth opportunities explanation has no prediction. 19

31 To this end, we estimate abnormal returns for an announcing firm and for the portfolio of other firms in the same country as the announcing firm. The benchmark for the announcing firm is the portfolio of all other firms in the same country. 10 The benchmark for the portfolio of other firms in the same country is the corresponding regional index (e.g., Asian Index for Korean firms). 11 We then split the portfolio of other firms in the same country into two sub-portfolios, namely the portfolio of domestic industry competitors and the portfolio of other firms in the same country but from different industries. The benchmark for the portfolio of domestic industry competitors is, like the announcing firm, the portfolio of all other firms in the same country. For the benchmark for the other sub-portfolio, we continue to use the regional index. As test statistics for the mean abnormal returns, we use z-statistics instead of t-statistics to account for a varying number of firms in a portfolio and, consequently, differential degrees of precision of the abnormal returns across portfolios. We use the Rank-Sum test for the statistical significance of the median abnormal returns. All portfolios in this paper are value-weighted. The firm-level analysis in Sections and will then show results that are equivalent to an equally-weighted portfolio. Panel A of Table 2 tests our first testing hypothesis. Consistent with previous studies (e.g., Miller (1999)), our sample announcing firms have a significant positive abnormal return. However, the portfolios of other firms in the same country, on average, do not show any significant stock price movement around the announcement date either statistically or economically. This is not inconsistent with the growth opportunities benefit but makes the risk premium benefit implausible. Given the strong impact on the announcing firm, other firms in the 10 Alternatively, we used Datastream Country Index and found virtually identical results, but with the Datastream Index, the number of observations is reduced by one to 68. Therefore, we proceed with the portfolio of other firms in the same country. 11 The regional indexes are from EMDB. For the period when EMDB regional indexes are not available, we construct the index using all EMDB Global Index firms in that region covered by Datastream. 20