The Evolution of U.S. Stock Market Regulations and the Flow of International Listings

Transcription

1 The Evolution of U.S. Stock Market Regulations and the Flow of International Listings Pratanphorn Piriyakul a, a Department of Finance, Cleveland State University, Cleveland, OH Abstract This paper examines the changes in attractiveness of U.S. and U.K. stock markets to foreign issuers as a consequence of changes in U.S. regulations, in particular, the enhanced listing requirements following the enactment of Sarbanes-Oxley (SOX) Act in 2002 and the new leniency introduced in 2007 via the amendment of Exchange Act Rule 12h-6. Using a sample of all foreign listing events on U.S. and U.K. exchanges from , I find evidence that, in contrast to what the literature suggests, the stringency imposed by SOX simply drives firms from poor governance countries away from the U.S., and this group of firms tends to migrate to the U.K. where regulations are more lax. When U.S. regulations for foreign issuers became less stringent after the Rule 12h-6 amendment, firms from countries with good governance desert the U.S. market while those from countries with weak governance move back to the U.S. market. Keywords: U.K. stock exchanges Sarbanes-Oxley Act, Rule 12h-6, International cross-listings, The U.S. and Corresponding author. Tel.: address: p.piriyakul@csuohio.edu (Pratanphorn Piriyakul) Preprint submitted to Elsevier January 7, 2017

2 The Evolution of U.S. Stock Market Regulations and the Flow of International Listings Abstract This paper examines the changes in attractiveness of U.S. and U.K. stock markets to foreign issuers as a consequence of changes in U.S. regulations, in particular, the enhanced listing requirements following the enactment of Sarbanes-Oxley (SOX) Act in 2002 and the new leniency introduced in 2007 via the amendment of Exchange Act Rule 12h-6. Using a sample of all foreign listing events on U.S. and U.K. exchanges from , I find evidence that, in contrast to what the literature suggests, the stringency imposed by SOX simply drives firms from poor governance countries away from the U.S., and this group of firms tends to migrate to the U.K. where regulations are more lax. When U.S. regulations for foreign issuers became less stringent after the Rule 12h-6 amendment, firms from countries with good governance desert the U.S. market while those from countries with weak governance move back to the U.S. market.

3 1. Introduction During the 1990s, the U.S. was a popular destination of foreign companies seeking to raise capital abroad. Evidence from Pagano, Röell, and Zechner (2002) shows that between 1986 and 1997 the foreign listings in the U.S. increased from 350 to 873. This striking increment employed by the U.S. did not appear to be a common trend in other markets. Most European stock exchanges, including London, for example, encountered a salient decline in new foreign listings. While at the same time, some of these exchanges even failed to attract new listings in their own markets. At the turn of the century, this trend appeared to be reversed (Zingales, 2007). A sharp decline in the U.S. market share of global IPOs from 48% in the late 1990s to 8% in 2006 as reported by Zingales (2007) raised public concern that the relative attractiveness of U.S. equity markets may have weakened. Zingales (2007) argues that the dramatic drop in foreign listings in the U.S. exchanges does not necessarily construe in the way that the benefits of U.S. listings have vanished, but only that the other competing equity markets may have finally caught up to the ability to provide similar benefits that the U.S. equity markets once exclusively provided. The slump of U.S. listings relative advantage cannot be easily attributed to one single factor. It is more likely that the concurrent action of multiple factors leads to this drop and many of which are certainly beyond the arm s length of the U.S. authority control. Still, there are some areas where the U.S. government can forcefully intervene, especially with regulations. In this study, I analyze the variation in attractiveness of the U.S. and U.K. stock markets by examining the listing decisions of foreign companies on the U.S. and the U.K. exchanges as a consequence of changes in U.S. foreign-listing-related regulations, including the enactments of Sarbanes-Oxley (SOX) Act in 2002, which intensively magnified the 2

4 overall strictness of the U.S. market regulation and the amendment of Exchange Act Rule 12h-6 in 2007, which has introduced some leniency in reporting and deregistration requirements specific to foreign listings. In detail, the new Exchange Act Rule 12h-6 is considered the first significant deregulation of U.S. disclosure requirements since the passage of the 1933/1934 Exchange and Securities Acts (Fernandes, Lel, and Miller, 2010, p.130). It helps add more flexibility in the requirements governing when a foreign private issuer may terminate the Exchange Act reporting regime. Under the former rule, only a foreign private issuer with subject securities held of record by less than 300 U.S. holders, so-called the 300-holder provision, would be eligible for suspending its reporting obligations. During the suspension period, a company must continue annual verification that its number of holders of record remains below 300, and reporting duty would automatically resume whenever the holders of records exceed this number. The fact that a company could merely suspend, rather than terminate, would have made the possibility for a U.S. cross-listed firm to escape the Exchange Act reporting system slim. Difficulty of exiting could potentially be a disincentive to foreign companies accessing the U.S. public capital markets. With the new rule, a foreign private issuer of equity securities is allowed to terminate, for the first time, its reporting obligations under the Exchange Act by meeting the revised head-count method or the new alternative qualification benchmark relative average daily trading volume. With the introduction of this more achievable qualification criteria and the permission for a foreign issuer to terminate its reporting duties and therefore permanently leave the U.S. market regulations, the new Exchange Act Rule 12h-6 would have made the U.S. market less intimidated, especially to foreign firms that have not yet cross-listed, and less costly and should thereby encourage more international listing activities. 3

5 As posited in Zingales (2007), listing decisions of foreign firms are an effective indicator of a market's legal standing. With a wide range of alternative markets to choose from, a firm's foreign listing decision is most sensitive to the costs and benefits offered by each listing location. Assuming the U.S. and U.K are two alternate markets that a given pool of foreign firms consider preferable, if due to changes in U.S. regulations, costs and benefits of U.S. listings were not in favor of this set of firms, the U.K. would then become a more favorable market for foreign listings. Nevertheless, it is important to note that in the case where an increase in relative attractiveness of the U.K. market is observed, it does not necessarily indicate that attractiveness of the U.S. market has declined. As discussed in Doidge, Karolyi, and Stulz (2009a), the variation in relative attractiveness of a listing location will occur either when the bundle of attributes of a listing location changes, or when there is a shift in attributes of the firm itself. Changes in firm characteristics could have made the U.K. more attractive even if the bundle of attributes of U.S. listings remain unchanged. Therefore, a conclusion cannot be made with certainty that the U.S. market has lost its attractiveness simply by being witnessed with a decline in the flow of new foreign listings in the U.S. or an increase in the flow of new listings in the U.K.. For better understanding, Doidge et al. (2009a, p.254) drew an analogy for this situation by saying an increase in Nice's market share of tourism market compared with St. Moritz's does not necessarily mean that St. Moritz has become less competitive. It could just mean that the season has changed. Applying this rationale, I evaluate the impact of U.S. foreignlisting-related regulations on the attractiveness of U.S. and U.K. markets by categorizing firms into groups according to their characteristics, especially their corporate governance, and observing reactions of each set of firms to each regulation. Such an approach allows me to effectively control the variation in firm characteristics which might confound the 4

6 firm decision in choosing a listing location as a consequence of changes in U.S. regulations. Similar to other studies (e.g., Doidge et al., 2009a; Duarte, Kong, Siegel, and Young, 2014; Piotroski and Srinivasan, 2008), I choose the U.K. Main Market as an alternative listing location for the U.S. listings. Both the similarities in market attributes and the differences in mandatory regulations made the London Stock Exchange 's (LSE) Main Market the most legitimate benchmark market for this study. Among all major exchanges, the LSE's Main Market is the most comparative to the U.S. markets according to market size and frequency of foreign listing activity perspectives. Doidge et al. (2009a) report that in 1998 approximately 30% of all foreign listings in the world occurred in the U.S. major markets, and roughly 16% happened in the LSE's Main Market and Alternative Investment Market (AIM), while no other exchanges had more than 7%. Also, from the World Federation of Exchanges monthly report as of December 2012, the London Stock Exchange group was ranked the third by market capitalization after the NYSE and the NASDAQ. Despite the resemblance between their market attributes, the approaches to corporate governance in the U.S. and U.K markets are very much different. The U.S. corporate governance system is mandated by a rule-based approach, which is determined predominantly by legislation in the form of the Sarbanes-Oxley Act of All U.S. exchange listed companies are obligated to comply with the SOX requirements where strict penalties including fines and imprisonment are generally anticipated for noncompliance. The corporate governance regime in the U.K., in contrast, is driven mainly by the U.K. Corporate Governance Code (formerly known as Combined Code) which is a principle-based approach, not a law. With the Comply or Explain approach employed by the U.K. Corporate Governance Code, U.K.public firms are in general required to provide expla- 5

7 nation in their annual reports as to whether or not they comply with the Code and give reasons for noncompliance. It is also worth noting that the Combined Code does not necessarily apply to all U.K. listed firms. Foreign firms seeking secondary listings in London are the first group to be exempted from the Combined Code provisions (Coffee, 2007). Foreign firms that access the LSE s Main Market via depositary receipts (hereafter, U.K. DR) also have leeway in the reporting requirements. Basically, the U.K. DR listing firms are not required to file financial reports prepared in the same manner with U.K. or U.S. GAAP or International Accounting Standards (IAS). According to the bonding hypothesis proposed by Stulz (1999) and Coffee (1999, 2002), the difference in corporate governance stringency between the U.S. and U.K. markets would lead to disparity in benefits and costs between the U.S. and U.K. cross-listings and could affect listing preferences of foreign firms. Preference for listing locations could also differ by the variation in costs associated with regulatory compliance and changes in corporate governance incurred to firms with different attributes. For instance, firms from poor governance countries would be subjected to higher compliance costs than do firms from countries with good governance when listing on a market with vigorous regulations. In particular, the wider discrepancy between corporate governance structure of a firm s jurisdiction and corporate governance structure of a cross-listing market would induce the higher compliance and governance transitioning costs, which thereby lower the net benefits that the firm could perceive from a listing location. Consistent with this view, Coffee (2002) argues that it is possible to not observe a unifying international listing flow toward only the reputational exchanges like NYSE and NASDAQ. A regional super-market (term used in Coffee (2002)) may still remain its importance to the extent that many issuers cannot meet the listing standards of the NYSE or NASDAQ or find a 6

8 U.S. cross-listing too costly. Firms with less interest in attracting minority investors, but still yearning to some degree for liquidity, may prefer to only trade on lower disclosure exchanges. Such a circumstance could have made London, for example, a listing destination for those foreign firms that find the U.S. exchanges intimidating. This rationale is consistent with MacNeil and Lau s (2001) finding indicating that London appears to be attractive to foreign firms that seek cross-listings for purposes other than bonding, as witnessed by the presence of considerable exceptions from the listing rules made for foreign firms listed in the London Stock Exchange. The Rejchrt and Higgs s (2015) evidence of lower levels of compliance with the Code by the LSE cross-listed companies, especially those from countries with weak corporate governance, further emphasizes the link between corporate governance divergence and preference for cross-listing locations. Additional evidence of an upward trend in quality of corporate governance of foreign firms listed in New York post SOX and a downward trend in governance quality of foreign firms listed in London during the same period, presented by Doidge et al. (2009a), also supports this view. After all, it appears that much leniency and considerable exceptions for regulatory compliance would have made the U.K. market a popular destination among firms from poor governance countries seeking international listings. This pattern, however, could be altered if stringency in corporate governance in the U.S. or the U.K. somehow varies, perhaps by changes in regulations. Using a sample of all foreign listing events on U.S. and U.K. exchanges from , I develop a cross-listing decision model which incorporates firm-, industry-, exchange-, and country-specific factors to describe the variation in foreign listing decisions over time. Consistent with prior research, I find that U.S. exchanges are more likely to attract firms that are larger in size, lower in leverage, operating in high-growth industry, and are less 7

9 likely to attract firms that are domiciled in countries with relatively weaker governance regimes. At the exchange level, I find that foreign firms are more likely to choose an exchange that has a better market performance and a stronger corporate governance structure. I also find that firms tend to be attracted to a particular exchange on account of geographic characteristics. For instance, Canadian firms are more likely to cross-list in the U.S., while Irish firms and firms that belong to the European Union (EU) are more likely to cross-list in the U.K.. Last but not least, I discover that the variation in attractiveness of U.S. and U.K. due to changes in U.S. foreign-listing-related regulations differs greatly at the country-level characteristics and not so much at the firm-level. Especially, I find that the level of corporate governance standards of the firms countries plays a large role in determining firms preference in listing locations. After adjusting for firm characteristics and other economic determinants, the results from the multinomial logistic regression analysis illustrate three main U.S. regulatoryrelated findings. First, I find that SOX does not necessarily make the U.S. market less attractive than the U.K. as some studies argue (e.g., Berger, 2005; Duarte et al., 2014; Li, 2014; Litvak, 2007a,b; Marosi and Massoud, 2008; Zingales, 2007). By separating firms into two groups according to the strength of corporate governance in firms jurisdictions, I find the U.S. markets became more attractive after the enactment of SOX especially to firms from strong corporate governance countries. No similar evidence is found in the case of U.K. cross-listings. In addition, when comparing the U.S. cross-listings with the U.K. ordinary and the U.K. DR listings, I find the U.S. cross-listings remain attractive in the SOX period. Between the two U.K. listing venues, it is only the U.K. DRs that are highly attractive in the post SOX period while the U.K. ordinary listings do not show any distinct attractiveness. In fact, I find that the attractiveness of the U.K. DR listings are 8

10 limited only to a group of foreign firms from countries with poor governance standards. A large extent of leeway in corporate governance that foreign firms receive when accessing the U.K. capital market via depositary receipt program could be the reason of such a finding. Together, this evidence infers that the stringent requirements introduced by SOX appear to drive firms from countries with weak governance structures away from the U.S. markets and these firms appear to divert themselves to the U.K. in which listing requirements are more lax. Second, I find that Rule 12h-6 further boosts the attractiveness of the U.S. markets. However, this increment is unsubstantial. In particular, a significant advancement in the U.S. market attractiveness is only detected among a set of firms from poor governance countries. Firms from countries with good governance structures, however, appear to be deterred by the new rule. In contrast to the U.S. markets, I discover a significant incline in attractiveness of the U.K. Main Markets post Rule 12h-6. In particular, I observe the persistence in the attractiveness of the U.K. Main Market among firms from countries with poor corporate governance regimes, similar to the post SOX evidence. I also find an increase in the attractiveness of the U.K. Main Market among firms from good governance countries in the post Rule 12h-6 period. This study provides both empirical and practical contributions. To the best of my knowledge, this study presents the first empirical evidence of the economic consequence of the changes in U.S. regulations, especially the market deregulation event through the enactment of Rule 12h-6, on the attractiveness of U.S. and U.K. cross-listings. My study contributes to the empirical research on the costs and benefits of each movement in U.S regulations, as evidenced by the flow of international listing companies that each regulation attracts to or drives away from the U.S. securities markets. I also make an important 9

11 practical contribution by providing evidence that stringent regulations such as SOX are not necessarily considered a bad move as many researchers argue. In fact, the toughness brought by SOX helps improve market quality by filtering out inferior firms from the U.S. markets, which thereby helps to strengthen investor confidence and fuel market development. In contrary to SOX s effect, findings with regard to the impact of Rule 12h-6 points out that regulatory loosening could potentially create an unintentional loophole by endangering market quality. Leniency in the new deregistration requirements and processes could have made investors suffer the costs of losing information and protection when currently registered foreign companies terminate their Exchange Act registrations and reporting obligations in response to the new rule. As such, the influx of firms from poor governance countries to the U.S. as a consequence of Rule 12h-6 could be a sign of deterioration in U.S. market quality, and this should raise questions as to whether the new Exchange Act Rule 12h-6 effectively strengthens the U.S. market competitiveness as intended. The implications of this study is that U.S. regulations and attractivenesses of the U.S. market are tightly related, and international listing flow is one possible indicator for evaluating success in regulatory movements. A rigorous regulation proves to be a two-sided sword. It promotes raring degrees of perceived market quality, while at the same time it can dissuade some foreign firms from pursuing U.S. cross-listing. The same story also applies to when regulations are relaxed. Loosened regulatory requirements can potentially demean the quality of a market as it is perceived by investors. In such cases, the U.S. markets run the risks of losing their prestige of being a benchmark market for the world's highest listing standards. With all these possibilities, it is vital that government agencies place their highest attention to reactions of firms to past regulations. Historical 10

12 market reactions, both intentional and unintentional, are critical for ensuring that U.S. regulations maximize and maintain the competitiveness of the U.S. markets in the future. The remaining of the paper proceeds as follows: Section 2 provides a review of related literature and testable hypotheses. Section 3 describes the sample and variables. Section 4 presents and discusses the empirical findings. Section 5 concludes the paper and points to some paths for future research. 2. Review of related cross-listing literature and hypotheses development 2.1. Review of related literature Equity Financing, Corporate Governance, and Importance of Cross-listing Without doubt, raising capital is one of the most challenging pursuits of any business. In a common situation, a firm may find it less difficult to finance its projects with debt relative to equity. This is because, with debt financing, financiers can assure of their certainties in getting back the returns of investments through a well-written contracts with prespecified obligations. A debt contract in general contains formative requirements in which a borrower is obligated to make a predetermined stream of future payments to the lender in exchange for the lender's funds, and the lender occupies certain rights over the borrower's assets if the borrower defaults on a payment. Such a contract, therefore, takes care a great deal of investment risk borne by debt financiers. Equity financing, in contrast, is not associated with any contractual agreements that an entrepreneur must make between himself and financiers. If not protected by laws, financiers have no certainty of getting returns on their investments. Risks borne by equity financiers in such a circumstance are, therefore, simply perfect. With these reasons, raising funds via equity financing appears to be a difficult task for most businesses. 11

13 To gain better insights into equity financing dilemma, Stulz (1999) provides an example of a firm with a large project which management believes to be profitable and must be financed. The project cash flows that management anticipates and the ones that outside investors believe the project to generate are not necessarily identical. Stulz (1999) explains that the discrepancy between the project's values assessed by management and prospect investors could exist for at least two reasons. The first cause of this discrepancy is called information asymmetry (see Akerlof, 1970). The nature of information asymmetry arises from the fact that information about a company is not shared perfectly throughout all stakeholders, especially outside investors. Management in general possesses more or superior information of firms and their projects than do outsiders, and important information regarding business prospects tends to be severely withheld inside the company. Although there may be some occasions that managers may have to yield up the company information to public (e.g. when raising capital), managers may only make a minimal allocation or may make untruthful information sharing. Without reliable and adequate information, outside investors are, therefore, unable to assess the value of a firm's projects that truly reflects the firm's circumstances. As a result, the deviation in a firm s equity price from what managers expect is likely to occur, most likely in unfavorable way. For example, Bhattacharya, Daouk, and Welker (2003) find that countries with earnings opacity problems tend to have narrow financial markets with limited trading activities. Firms residing in such countries, therefore, generally experience very high costs of capital. Besides information problem, the divergence in valuations of project cash flow assessments could also occur due to the conflict of interests between investors and management, often referred to as agency problem (see Coase, 1937; Fama and Jensen, 1983a,b; Jensen 12

14 and Meckling, 1976). Agency problem occurs due to a nature of business when a decision making and risk bearing functions are separated. In a typical shareholder-manager relationship, as outsiders who not only have a limited access to inside information of corporation and management but also have to bear the sole risk of their funds, shareholders face problems ascertaining whether management is acting in the best interests of the organization by making the best use of firms capital. Besides managers, outside shareholders would also suffer the risk from expropriation by controlling shareholders such as a business founder and his family, who own majority of the outstanding shares in a company, thereby hold more control rights in the firm and more controlling power over the firm's managers. (Hereafter, I refer to both managers and controlling shareholders as the insiders. The terms outsider investors and minority shareholders will be used interchangeably throughout the paper.) Expropriation by insiders can take various forms. At one extreme end, insiders can simply steal corporate's profits. In such case, outside investors are put at a perfect risk since the returns of their investments from financing firms will never occur. In reality, expropriation would, however, happen in a more subtle fashion such as executives overpayment, wasteful projects engagement, and any non-contractible managerial benefits from running a company (e.g. perquisite consumption). After all, no matter how expropriation occurs, by not having power to control the firms, outside investors are always put at a disadvantage. In actual fact, no rational investors would be willing to invest their money in firms if protection for their rights in such a country is weak. Rather, those investors may prefer investing in government securities or, in the worst case, put their money in mattresses. Taken together, the presence of information and agency problems would hamper firms from raising capital for their business expansion. In particular, managers might struggle to raise enough funds to 13

15 launch the projects. And even supposing they are able to raise the necessary funds, the existence of these two problems could make the new equity capital prohibitively expensive (Stulz, 1999). Corporate governance comes into the picture here. Corporate governance involves mechanisms assuring outside investors of the certainty of getting return on their investment (Shleifer and Vishny, 1997), and these mechanisms can occur either externally (e.g. laws and regulations) or internally (e.g. board structure). However, as proposed by Shleifer and Vishny (1997) and La Porta, López de Silanes, Shleifer, and Vishny (2000), among others, legal protections of investor rights appears to be the most effective approach to corporate governance. As Hart (1995) argues, investors get cash back from investing their money in the firms projects only because they have power to do so. In equity financing, this power, in the form of voting rights of shareholders, can be the power to request for an ongoing disclosure, to force dividend payments, to call for extraordinary shareholders meetings, to select, remove, or change directors, to sue directors for expected expropriation, to stop managers from undertaking value-reducing projects, and to subscribe to new issues of securities on the same terms as the insiders, etc. When these rights of investors are well-protected by law and can be effectively enforced by regulators, courts, or litigations and when firms are obligated to commit with such governance practices, the expropriation technology becomes less efficient, the insiders can expropriate less, and the private benefits of control become weakened (La Porta et al., 2000). After all, by shaping their corporate governance standards, the countries also shape the prospects of their external finance (La Porta, López de Silanes, Shleifer, and Vishny, 1998; La Porta et al., 2000). It is not only that firms residing in such countries could raise the necessary funds for launching their projects, but they could also acquire 14

16 those funds in much better terms. Supporting this rationale, Dyck and Zingales (2004); La Porta, López de Silanes, Shleifer, and Vishny (1997); La Porta et al. (1998); Shleifer and Vishny (1997), and Shleifer and Wolfenzon (2002) find that securities markets of countries with strong legal protection and enforcement appear to be deep, liquid, and advanced. The empirical evidence also shows that firms having their equities traded in countries with strong investor protection are found to have cheaper costs of capital (Hail and Leuz, 2009) and better stock prices (Doidge, Karolyi, and Stulz, 2004; Doidge et al., 2009a; Duarte et al., 2014; La Porta, López de Silanes, Shleifer, and Vishny, 2002; Reese and Weisbach, 2002). In spite of the presence of benefits from having good corporate governance, it is surprising to find firms that resist governance improvement such as firms residing in countries with poor governance structures. Under normal circumstances, firms in such countries often find themselves well-off under their current governance regimes and therefore have less desire to expose themselves to better governance systems. In a random occasion, there may be firms that are yearn to adopt good governance but unable to do so because of the cost-related issues or limitation of mechanisms necessary for governance improvement in their countries. Under such conditions, firms may find that they cannot simply rely on changes in their home country laws since the revision of investor protection in general requires radical changes in the legal system, which includes not only the changes in legal structure itself, but also the changes in political and cultural elements (Bebchuk and Roe, 1999; Roe, 2002). Fortunately, financial globalization could offer one such solution for firms to leapfrog their local impediments to stronger laws necessary for stronger securities market (Stulz, 1999). This is where cross-listing enters the picture. Cross-listing - also referred to as 15

17 foreign listing, international listing, dual-listing, or cross-boarder listing - is an important financial invention helping a firm seeking an overseas market for secondarily listing and trading its shares currently registered in a home market exchange elsewhere. Cross-listing provides a means for firms to opt in regulatory regimes of other countries, besides their own jurisdictions. And by cross-listing in countries of which corporate governance regimes are stronger, firms could attain the similar governance benefits secured by other domestic firms domiciled in such countries Cross-listing details When it comes to cross-listing, it may or may not associate with a capital raising. To cross-list, a firm may do it via an ordinary approach by directly listing its shares on the overseas exchanges (called direct listing or ordinary listing ), or the firm may list its shares in the form of Depositary Receipts (DR). Two common forms of the DR programs include the American Depositary Receipts (ADR) and the Global Depositary Receipts (GDR). Their names simply represent the markets where they are listed and traded. For example, an ADR is listed and traded on exchanges based in the United States, while a GDR is commonly listed on non-u.s. exchanges such as the London Stock Exchange, NYSE Euronext (Europe), Deutsche Börse, the Stock Exchange of Singapore, and Hong Kong, etc. Both ADRs and GDRs are usually denominated in U.S. dollars, and they represent the ownership and all rights such as voting rights and cash dividends of the issuing firms identical to those granted to shareholders of ordinary shares. When a local firm wants to list its shares aboard via a DR program, it follows a standard procedure. The firm will start with hiring a financial advisor to help it navigate regulations of the target country, and will choose a local custodian bank and the depositary bank which generally is a financial institution that is located in the overseas country 16

18 where the firm is planning to sell its equities. Next, the firm will decide the number of shares to be represented by the depository receipt, referred to as the depository receipt ratio, and finds a broker in the target country who is willing to purchase the firm's shares. Once being purchased from the local market through an international office or a local brokerage house of the broker, the local shares will be delivered to the local custodian bank of the depository bank. After verifying the delivery, the local custodian bank then informs the depositary bank that the shares can now be issued in the target market. The depositary bank then delivers the DRs to the broker who initially purchased them. Thereafter, the DRs now represent the local shares held by the depository and can be traded freely among investors in the overseas market like any other securities. In order to opt in stronger governance practices by cross-listing, the choice of listing venues is of primary importance. For instance, when cross-listing in the U.S. via an ADR program, issuers have two major groups of programs with a total of four different options to choose from: Unlisted programs, including Level I and Rule 144A, and Listed programs, including Level II, and Level III. Each group and type of ADR programs has its own unique attributes and offers different implications for firms corporate governance, future financing decision, and U.S. investor base. For example, unlisted programs do not require firms to fully commit with SEC registrations, nor do they require the firms to report results according to U.S. accounting guidelines. Unlisted programs obviously do not offer much governance bonding benefits to the firms. And, by not fully committing with SEC regulations, firms shares registered under the unlisted programs are not allowed to be traded on any U.S. exchanges. Despite sharing many common features, the two ADR options under the unlisted program - Level I and Rule 144a - are also very different when it comes to the ability to raise new capital and trading channel issues. With Level 17

19 I ADR, firms shares are traded publicly on the over-the-counter (OTC) market, but firms are restricted from issuing new shares for raising new capital. Rule 144A, on the other hand, offers an access to the U.S. primary capital markets. However, firms shares traded via Rule 144A program can only be sold privately to Qualified Institutional Buyers (QIBs) as a private placement via the PORTAL market. Contrary to unlisted programs, firms shares registered under the listed programs can be traded on U.S. exchanges. When firms shares are traded under the listed programs, the overseas companies must follow the same practices as all other U.S. domestic public companies do by registering with the SEC and complying with the disclosure and reporting obligations mandated by the U.S. accounting laws. The major difference between Level II and III is that Level II ADRs limit an issuer's access only to the U.S. secondary markets, whereas Level III ADRs offer an access to both U.S. primary and secondary capital markets. In addition, Level II ADRs require issuers to partially reconcile their accounting information with the U.S.GAAP, mainly for the different accounting items, while Level III ADR issuers must have full U.S. GAAP reconciliation. As previously discussed, besides ADR programs, foreign firms can also list their shares directly on the exchange as ordinary issues. Despite the fact that the process of ordinary listings may not be as convenient as ADR programs, ordinary listings share the same attributes as the ADR listed programs, especially the Level III ADRs. In particular, both ordinary issuers and Level III issuers are obligated to fully commit with SEC registrations and disclosure and reporting requirements. Both listing venues also allows firms to trade their current shares in the secondary markets and issue the new shares and sell them in the primary markets. It is, however, worth noting that the details of U.S. cross-listing venues discussed above 18

20 do not necessarily apply to other cross-listing venues in other countries. For instance, in London, the listing rules applicable to foreign issuers are substantially more lax than those applicable to the U.K. s locally incorporated issuers. Even if listings on the same exchange e.g the LSE s Main Market, foreign firms with ordinary issues are not necessarily required to abide by the same amount of listing rules as those required for firms with DR issuances. The U.S. DRs and U.K. DRs are therefore incomparable listing venues as the extents to which corresponding issuers must involve with regulatory compliance from issuing these DRs are not the same. After all, we learn that cross-listings provide a means for firms to circumvent their local impediments to stronger laws. Firms no longer have to rely on their countries success in legal movements in order to attain superior governance standards necessary for deep, developed financial markets. With the presence of cross-listing, firms can even pursue cross-border trading without having their financial markets liberalized. We also learn that attributes of listing venues and listing locations are also of primary importance. The variations in attributes and requirements of listing locations and listing venues suggest that governance benefits offered by each listing option are not necessarily the same. The cross-listing venues and locations which commit firms to stronger investor protection environments would generally offer greater benefits. In the next section, I will discuss the benefits of cross-listings that could motivate firms to seek this path and the unifying reason cited as the fundamental motive of cross-listing decision Why do firms cross-list? The role of cross-listing in circumventing difficulties of cross-border trading and its various benefits that foreign firms may obtain have made a large number of firms to pursue this route. Supporting this view, Gagnon and Karolyi (2010) documents that the total 19

21 number of foreign listing across all exchanges has risen from only 2,738 in 2004 to 3,045 in Also, the total cross-border capital flows between U.S. residents and all other countries, measured by the sum of gross purchases by foreigners from U.S. residents and gross sales by foreigners to U.S. residents of long-term domestic and foreign securities, reported by the U.S. Treasury International Capital shows a similar pattern. In 1979, the total cross-border capital flows were around $6 billion. The flows were over $800 billion by 1999, and reached $4.2 trillion by During the market turbulence between 2008 and 2009, gross capital flows declined to $1.7 trillion, most likely due to significant drop in market valuation of large stocks and bonds. After the economic downturn, gross capital flows have started to pick up their growth again; by the end of 2015, the gross capital flows rose to over $3.5 trillion. This growing importance of cross-listings have led to the presence of several research initiatives to explain the motivation that has made firms seek this route. A large number of empirical studies have been conducted to uncover this issue. Due to variation in firms and their countries attributes, it is not uncommon to see diversity in firms cross-listing motives such as (1) to obtain an access to larger and deeper pools of capital (see Lins, Strickland, and Zenner, 2005a; Reese and Weisbach, 2002) (2) to improve their liquidity (see Chung, 2006; Eleswarapu and Venkataraman, 2006; Moulton and Wei, 2009; Silva and Chávez, 2008) (3) to broaden their shareholder base (see Pagano et al., 2002) (4) to increase investors recognition on their equities, their visibility, or their reputation (see Baker, Nofsinger, and Weaver, 2002; King and Segal, 2009; Siegel, 2005). In spite of this discrepancy found in cross-listing literature, Karolyi (2006, p.141) points out in his survey study that...there is a unifying theme in these various initiatives in that they all emphasize the growing importance of corporate governance issues 20

22 in the cross-listing decision. Indeed, the essence of corporate governance as a main drive behind all benefits that local firms may achieve when cross-listing has been found in a number of studies across all research initiatives of cross-listing. For instance, the explanation for cross-listing proposed by the liquidity hypothesis emphasizes the firms desire to tap into a large pool of liquidity available in overseas markets as a main drive for cross-listing decision. Liquidity hypothesis, however, overlook one major fact that really matters, which is the role of laws and regulations of a cross-listing country on firms crosslisting decisions. As Coffee (2002) argues, in cross-listing decision, firms must choose a market and a regulatory regime together as a bundle package, and cannot detach their choice of market from their choice of regulatory principles. Because strong laws, stringent regulations, and all rigorous policies underlying trading rules are designed purposely to provide protections for outside investors against the expropriation by insiders, without such scrutiny, outside investors have no way to assure the integrity of financial markets where they are trading, which will, in turn, limit their confidence in trade and their trading activities. After all, securities markets tend to be more developed and more liquid when the countries corporate governance systems are strong (La Porta et al., 1997, 1998). With these means, firms cannot simply access a deep, liquid market while committing only with flimsy laws typically governing in a thin or undeveloped market. The argument that liquidity benefits would not emerge if the cross-listing markets are not backed by strong laws has been witnessed by a large number of studies. For example, Beny (2005) finds that countries with more prohibitive insider trading laws have more diffuse equity ownership, more accurate stock prices, and more liquid stock markets. Similarly, La Porta, López de Silanes, and Shleifer (2006) show that interaction between disclosure rules and threat of liability through private enforcement facilitates 21

23 stock market development. Cumming, Johan, and Li (2011) examine the importance of stock exchange trading rules for market manipulation, insider trading, and broker agency conflict on market liquidity improvement. By investigating the differences in trading rules of 42 exchanges around the world, Cumming et al. (2011) find a strong positive connection between trading rules and liquidity. Together, these findings imply that various benefits of cross-listings which motivate firms to pursue such routes, in fact, primarily stem from one common logic - the improvements in corporate governance of the firms new trading environments Bonding hypothesis The emphasis of corporate governance as a unifying theme in various research initiatives for cross-listing have led to a popular initiative widely known as bonding hypothesis proposed by Stulz (1999) and Coffee (1999, 2002). The essence of bonding hypothesis relies on the role of corporate governance in mitigating information and agency problems. Coffee (1999, 2002) argues that cross-listings provide a means for firms to bypass political, cultural, and other impediments to stronger securities laws in their own jurisdictions by renting the securities laws and enforcement in other countries where the presence of legal framework necessary for strong securities markets does exist. A tougher regulatory environment of cross-listing countries such as that of the U.S., which includes higher disclosure and reporting requirements, and greater exposure to regulatory oversight, enforcement, class actions, and scrutiny of reputational intermediaries such as underwriters, rating agencies, auditors, and securities analysts, has made it harder and more costly for insiders to extract private benefits of control from outside investors. Cross-listing, hence, represents an intention of company insiders to circumvent information and agency problems and would be perceived as favorable management actions. The bonding hypothesis 22

24 predicts that global investors would typically response to cross-listing events in a positive manner, as witnessed by empirical evidence such as a decline in capital costs (Hail and Leuz, 2009; Stulz, 1999) and an increase in equity valuation (Gozzi, Levine, and Schmukler, 2008; Sarkissian and Schill, 2009). It should also be noted that the magnitude of such cross-listing benefits depends critically on corporate governance of firms home and host countries, or to be more precise the improvement in corporate governance. For instance, with all else being equal, foreign firms from countries with weaker legal institutions would obtain larger benefits, such as higher equity valuation surprises, than do those from stronger governance countries. Besides benefits, costs of cross-listing is also important. Under the bonding hypothesis, costs come to play in many decision-making scenarios such as should a firm cross-list? and if so, when and where?. Management could only make an effective decisions for such questions if all benefits and costs associated with each listing choice are fully assessed. In sum, costs of cross-listing consist of (1) listing fees and other expenses associated with listing procedures, (2) compliance costs to laws, regulations, and governance standards of a cross-listing market e.g. audit fees and other administrative costs, (3) opportunity cost occurring from loss of insiders opportunities to extract private benefits of control due to corporate governance mechanisms of a cross-listing market (see Ayyagari and Doidge, 2010; Doidge, 2004; Doidge, Karolyi, Lins, Miller, and Stulz, 2009b), and (4) opportunity cost of staff burdens from spending more time and resources in order to comply with the new laws, regulations, and requirements. The same rationale applied to the benefits would also hold true for the costs aspect that, ceteris paribus, cross-listing would incur varying costs to foreign firms depending on the degree of divergence of firms corporate governance structure from that of a cross-listed country. Firms would be subject to larger 23

25 governance improvement and transitioning costs if there were wide discrepancies in governance structures between their home and host markets. In addition, insiders of foreign firms would suffer larger opportunity costs from loss of private benefits of control when the new listing environments impose a drastic improvement in transparency to the firms business practices. Taken together, benefits and costs of cross-listing stemming from improvement in corporate governance play a large role in determining firms overseas listing decisions. Firms will cross-list only if all costs associated with a listing location are underweight the corresponding benefits, and, among all market choices, a listing location offering the highest net benefits would be chosen Research hypotheses Corporate governance in the U.S. and U.K. and the flow of international listings The U.S. and U.K. equity markets have long been closely competitive. Doidge et al. (2009a) report that in 1998 approximately 30% of all foreign listings in the world occurred in the U.S. major markets and about 16% happened in the London Stock Exchange s Main Market and Alternative Investment Market (AIM), while no other exchanges had more than 7%. By December 2012, according to the statistics report by the World Federation of Exchange (WFE), foreign listings in London increased to about 19%, whereas the foreign listings happened in NYSE and NASDAQ together declined to 27%. In fact, foreign listing occurring in NYSE alone was only 17%. This evidence appears to be consistent with what was mentioned by Doidge et al. (2009a) that It is now almost conventional wisdom in policy circles and in the financial press that London has become more competitive in attracting foreign listings than New York. (p. 254). Certainly, a growing body of research and public intention of such criticism has been 24

26 highlighted on the difference in governance and disclosure philosophies of the U.S. s and U.K. s markets. Despite being founded on the same legal system common law, the approaches to corporate governance adopted by these two countries are very much different. On the one hand, being well known for richness in its legal body and its highintensity enforcement, the U.S. has embraced the corporate governance system mandating its publicly-listed firms via a rule-based method, in which the SEC and the exchanges are responsible for implementing and enforcing good corporate governance practices. Similar to the other U.S. laws primarily regulating the U.S. markets, including the Securities Act of 1933 which regulates the offer and sale of securities in the U.S., and the Securities Exchange Act of 1934 which governs the trading of securities on the U.S. securities exchanges and ongoing periodic reporting, all exchange-listed firms 1 must abide by the corporate governance-related requirements imposed by the SOX Act. Strict penalties, including fines and imprisonment, are generally anticipated for noncompliance or violation. The U.K., on the other hand, has been acknowledged as a softer-law country compared to the U.S. A liberal policy in disclosure and governance standards mandating the U.K. publicly-listed firms known as the U.K. Corporate Governance Code (formerly called Combined Code) is of a primary evidence of the U.K. regulatory leniency. In particular, the key contents of good-practice standards set out by the U.K. Code, such as board leadership and effectiveness, remuneration, and accountability and relations with shareholders, are relatively similar to those requirements imposed by SOX. It is, however, very important noting that the U.K. Code is not a law: It simply is a principle. In essence, the provisions of the Code are not mandatory. Known as Comply or Explain 1 In general, the U.S. does not treat its foreign issuers more specially than treating its own domestic companies. The only special permission that SEC makes to foreign issuers is to exempt them from a periodic disclosure requirement at a quarterly basis and, instead, require them to only file an annual report on Form 20-F. 25

27 approach, the U.K. listed companies are not obligated to comply with the Code provisions but are required to provide explanations in their annual reports as to whether or not they comply with the Code and give reasons for non-compliance. From a domestic firm s view, this flexibility in the U.K. listing rules is already striking enough. For foreign issuers, however, this is not quite the whole package yet. In fact, perhaps to attract more overseas listings, the U.K. authorities bend the listing rules in foreign companies favor by making several permissions for these firms to not comply with the typical rules generally applied to the U.K. domestic firms. For instance, overseas firms that seek secondary listings on the LSE s Main Market are exempted from the provisions of the U.K. Listing Authority s listing rules that intend to protect the minority investors, such as the U.K. listing rules regarding preemptive rights (Coffee, 2007). These firms are also immunized from the U.K. Corporate Governance Code compliance. Further concessions are likewise made for overseas companies entering the U.K. Market via DR issues 2. In effect, such a circumstance should undoubtedly make many foreign firms turned on their listings to the London Stock Exchange in order to avoid what they perceive as unnecessary and costly regulation that the United States imposes on foreignlisted firms. Evidence supporting which approach to corporate governance is more effective is still mixed. In his well-known literature Racing towards the Top?: The Impact of Crosslistings and Stock Market Competition on International Corporate Governance, Coffee (2002) argue against the claim that regulatory competition among securities markets 2 The DR firms are not required to file financial reports prepared in the same manner with U.K. or U.S. GAAP or International Accounting Standards (IAS). Instead, these firms are allowed to file financial statements prepared according to home country accounting conventions. Several exceptions made for the U.K. DRs stem from the reason that the market for depository receipts in the U.K. is dominated by sophisticated institutional investors. 26

28 will produce uniformity or any single winner. He instead views that differences among firms would produce specialized markets where each one cater to a different clientèle of firms. On the one hand, a higher-disclosure exchange such as the U.S. would still remain attractive to the extent that high-quality issuers seeking benefits from regulatory bonding and governance improvement, including higher share valuation and cheaper cost of equity, are still present. On the other hand, a lower-disclosure exchange such as London would still persist to the extent that some foreign firms would find the corporate governance system of the U.S. exchanges too intimidated or that their goal in cross-listing decisions is simply to seek for some liquidity improvement. It should also note that even though the conventional goal of a firm is to maximize the value of its shares, this goal is not necessarily the only rational goal of many firms when a firm is full of controlling shareholders who do not soon intend to sell their shares. In particular, a firm s goal in increasing its share value can be overridden by many reasons such as (1) the thirst of its controlling shareholders in sustaining the private benefits of control; (2) an interest to maintain business discretion and adaptability or to stay away from specific governance standards required by U.S. exchanges; or (3) the concern of corporate executives over enforcement penalties and the high exposure of private litigation in the United States (Coffee, 2007). Coffee (2007) points out that the critical issue for the controlling shareholder of the foreign firm (who in actuality is in charge for making cross-listing decisions) is whether the private benefits of control that it will suffer by accessing the U.S. market exceed the value to it of the equity valuation improvement and reduction in cost of capital that it will earn from cross-listing in the U.S. As a typical foreign firm has controlling shareholders, and expropriation by such groups tends to be more severe in a country where legal framework is weak (La Porta, López de Silanes, and 27

29 Shleifer, 1999), it is plausibly to believe that many insiders of firms incorporating in such countries would rather keep their current conditions unchanged so that their ability to extract private benefits of control would continue. If a liquidity issue in their countries is the primary reason for a cross-listing decision, insiders of such firms would prefer a listing location where some extent of liquidity is in the presence under the soft-law environment. In general, by incorporating in countries with lack of mechanisms necessary for strong corporate governance, firms own governance practices are likewise to be frail. Crosslisting in a country of which corporate governance structure is much stronger would not only incur significant costs associated with regulatory compliance and governance transitioning to the firms, such an action would also make insiders of the cross-listed firms suffering the great loss of giving up their private benefits of control. Taken together, I conjecture that an issuer who finds the U.K. an attractive destination for its oversea listing is in general a firm domiciled in a country with poor legal institution where insider issue is normally severe. Evidence supporting this prediction includes the information from Pensions Investment Research Consultants Ltd (PIRC) s 2004 Report showing that there were only 34% of FTSE All Share listed companies which were fully compliant. Further, Rejchrt and Higgs (2015) observe evidence of lower levels of compliance with key principles of the Code by foreign companies cross-listed on the London Stock Exchange, especially those from countries with weak corporate governance. My prediction is also consistent with MacNeil and Lau s (2001) argument that due to considerable exceptions from the listing rules and governance conduct made for foreign firms, the U.K. appears to be an attractive international listing destination for firms seeking cross-listing for benefits other than bonding. For the U.S., in contrast, I expect that the U.S. exchanges would likely to be an 28

30 international listing hub for foreign firms seeking unique benefits exclusively offered by the U.S. cross-listings such as premium valuation of equities (Doidge et al., 2004, 2009a), cheaper capital cost Hail and Leuz (2009), and superior liquidity improvement (Bailey, Karolyi, and Salva, 2006) without being intimidated by stronger laws and regulations. Under the same premise previously applied to the U.K. circumstance, I conjuncture that firms seeking U.S. cross-listings are likely to be those domiciled in countries with relatively strong legal institutions. By incorporating in countries where mechanisms necessary for good governance are present, firms are likely to have less severe controlling shareholder and expropriation issues. As a result, managers are more likely to make decisions for the best interest of the organization, rather than to protect the benefits of controlling shareholders or even the benefits of themselves. The role of private benefits of control as part of cross-listing costs existing when controlling shareholders were more severe would then become irrelevant. In addition, the narrower discrepancy in corporate governance qualities between the firms domicile countries and the U.S. would have made the costs associated with transitioning the companies governance structures to comply with the U.S. governance requirements become less obstructive. These firms would find themselves less struggling to meet governance requirements imposed by the SEC and other U.S. exchange-listing rules. Empirically, this prediction is supported by several findings. For instance, Kim, Sung, and Wei (2011) find that disparity in corporate governance between firms and investors countries is of importance to investors choices on portfolio holdings. In particular, investors from countries characterized by strong governance regimes such as the U.S. tend to shy away from investing in firms residing in countries with weak legal institutions. Similarly, Leuz, Lins, and Warnock (2010) find that U.S. investors invest less in firms domiciled in countries with poor investor protection and disclosure and have 29

31 ownership structure that could potentially induce governance issues. After all, these empirical findings imply that in exchanges with much better investor protection, there may be low demand for equities issued by firms domiciled in weak corporate governance countries. Taken together, these premises are consistent with Coffee s (2007) explanation that...the United States might be the listing venue for higher-quality issuers that wish to pursue strategic plans that require them to obtain low-cost equity financing or to bond with their shareholders, while London (and other markets) instead provides a comfortable refuge for firms with a control group intent on enjoying either the private benefits of control or unfettered discretion. The result is a separating equilibrium, as some foreign firms list in the United States to bond and others migrate to London to enjoy business as usual. (p ). This leads to the following hypothesis: H1: Discrepancy in stringency of U.S. and U.K. corporate governance in general would make the U.S. and U.K. markets attractive to different pools of foreign firms. In particular, ˆ The U.S. exchanges would be attractive to firms residing in countries with good corporate governance regimes; ˆ The U.K. Main Market would be attractive to firms residing in countries with poor corporate governance regimes The effect of SOX on foreign listings in the U.S. and U.K. Also known as the Public Company Accounting Reform and Investor Protection Act, Sarbanes-Oxley Act or SOX became a United States federal law on 30 July

32 as a comprehensive solution and emergency response to the 2001 infamous corporate scandals which prevailingly undermined the very heart of the federal securities laws the anti-fraud and mandatory disclosure - and public confidence in the U.S. public securities markets. The Act has set and raised a number of new corporate governance standards - ranging from additional corporate board responsibilities to criminal penalties - for all U.S. public company boards, management and public accounting firms. So far, SOX represents dramatic changes to the securities laws regulating corporate governance so that, when signing SOX into law, President George W. Bush characterized it as the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt. (Bumiller, 2002). Prior to the SOX enactment, corporate executives such as CEOs and CFOs had been paying little attention to the integrity and validity of their company's financial reports. At the same time, certifying and comments from the outside auditors of the company were also undependable as those corporate managers could intervene the independence in audit work and buy the auditors off. This circumstance placed outside investors at the poorest spot. The expose of corporate scandals did not only undermine public confidence in the U.S. public securities markets, but also disturbed the development of U.S. stock markets. To restore investors confidence and rule out future tragic events, the Congress enacted SOX with three major provisions aimed directly at the issues that caused the scandals. Section 302 requires that CEOs and CFOs of public companies certify that the company's periodic statutory financial reports do not contain any material that is untrue, material omission, or misleading information, and that the company's financial statements and related information fairly present the financial condition of the company and all other material issues. Also, the officers must assert that they are responsible for 31

33 internal controls, have recently evaluated these internal controls, and have reported on their findings which include a list of all weaknesses in the internal controls, information on any fraud that involves employees who are associated with internal activities, and any major changes in internal controls or related issues that could have an adverse effect on the internal controls (see SEC, 2003). Section 906 addresses criminal penalties, which can be as high as $5,000,000 in fines or/and 20 years in prison, for officers willfully certifying a misleading or inaccurate financial report (see SEC, 2003). Finally, and most crucially, Section 404 requires that management must generate an internal control report, as of the end of the most recent fiscal year, stating the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. The report must also contain an assessment of the effectiveness of the internal control structure and financial reporting procedures and must be attested to by the external auditor of its reliability (see SEC, 2003). Although most scholars have been extremely critical of SOX, especially the section 404, taken together, from investors'perspectives, SOX seems a logical response to effectively restore the market confidence. Empirical evidence supporting this view includes the positive market returns associated with the SOX legislative events (Li, Pincus, and Rego, 2008) and the higher announcement returns for foreign stocks announcing their U.S. cross-listings after SOX (Duarte et al., 2014). It is, however, important to note that SOX does not only amplify benefits of U.S. listings, but costs to comply with SOX also rise substantially. Ghosh and Pawlewicz (2009), Hartman et al. (2007), and Koehn and DelVecchio (2006) show that costs associated with U.S. cross-listings, especially the audit fees, increase considerably after the enactment of SOX. Iliev (2010) also observe an outrageous increment in audit fees due to the SOX Section 404 requirements. Similarly, 32

34 Marosi and Massoud (2008) argue that costs of SOX compliance could contribute to the deregistration decision of a large number of foreign firms. If the reasoning that the U.S. markets in general tend to be more attractive to firms residing in good governance countries and that the U.K. market generally would attract more firms from countries with weak governance regimes was valid, the presence of SOX should not change the circumstance, but rather making the results more pronounced. This is because SOX simply strengthens the corporate governance of the U.S. markets and therefore augments benefits and costs of U.S. cross-listings. Specifically, the greater exclusive benefits of U.S. cross-listings due to SOX such as higher valuation premium (Doidge et al., 2009a) and greater liquidity improvement (Jain, Kim, and Rezaee, 2008) would have made the U.S. exchanges even more attractive, relative to the pre- SOX period, particularly among firms characterized by U.S-exchange-eligible attributes. However, higher costs of governance transitioning arising from the wider discrepancy in corporate governance practices between the U.S. and other foreign counties due to SOX would make the U.S. exchanges a more disturbing listing location, especially for firms residing in countries with poor corporate governance regimes. Accordingly, among such firms, the enactment of SOX would aggravate the disfavor of U.S. cross-listings and would foster the importance of the U.K. market as an alternative listing hub. This prediction is found on several empirical findings. For example, Fernandes and Giannetti (2014) document a quadratic relationship between firms preferences for listing locations and differences in investor protections of firms home and host countries. The authors cite that while firms list abroad to subject themselves to superior laws, there is a limit to the degree of monitoring and scrutiny that firms can achieve. Essentially, firms may seek international listings in countries with stronger laws than their own; however, they would 33

35 stay away from listing locations where regulatory regimes are excessively stringent. Consistently, the evidence from Duarte et al. s (2014) study showing that insiders of foreign firms from countries with poor governance issue are more likely to avoid a U.S. listing after SOX than before. Taken together, this leads to the following hypothesis: H2a: Relative to the PreSOX period, SOX would pronounce the U.S and U.K. market attractiveness. Specifically, ˆ The U.S. exchanges would be more attractive to firms residing in countries with good corporate governance regimes post SOX, relative to pre SOX; ˆ The U.K. Main Market would be more attractive to firms residing in countries with poor corporate governance regimes post SOX, relative to pre SOX. As already noted about the U.K. cross-listing venues and their related attributes, between the two options - U.K. ordinary listings (hereafter, U.K. ordinary) and U.K. depositary receipts (hereafter, U.K. DR), the U.K. DRs appear to be a more attractive choice, especially among foreign firms unwilling to expose themselves to legal enforcement or changes in corporate governance at all levels. Accessing the U.K. Main Market via U.K. DR issues, foreign issuers obtain the greatest leeway in U.K. corporate governance and reporting compliances. Not only are firms exempted from several UKLA s listing rules and U.K. Corporate Governance Code, but they are also not required to file financial reports prepared in the same manner with U.K. or U.S. GAAP or International Accounting Standards (IAS). However, it is important to note that firms shares registered as U.K. DRs are not allowed to be traded by ordinary retail investors. In spite of 34

36 such fact, the liquidity of stocks traded as U.K. DRs may not be as high as foreign stocks listed as ordinary issues. In effect, U.K. DRs would be a suitable listing venue for foreign firms looking for a liquidity improvement, mainly from institutional investor trading, with very limited exposure to corporate governance. Since the U.K. general circumstances are already attractive to such a group of firms, it is plausibly that the success of the U.K. Main Market over the U.S. exchanges asserted by many scholars and public debate would come primarily from the allure of the U.K. DRs, not the U.K. ordinary listings. This reasoning leads to the following hypothesis: H2b: Relative to the PreSOX period, SOX would only pronounce the U.K. Main Market attractive among U.K. DR listings and would not have much impact on U.K. ordinary listings The effect of Rule12h-6 on foreign listing in the U.S. and U.K. In general, a foreign private issuer (FPI) will be subject to SEC registration and ongoing disclosure requirements of the Exchange Act 1934 once pursuing a U.S. crosslisting if it meets any of the following circumstances. (1) Securities exchange listing - Section 12(b): A class of a firm s equity securities is listed on a national securities exchange; (2) Issuer size - Section 12(g): The issuer s class of equity securities are held by more than 300 U.S. record holders and a total of either (a) at least 2,000 record holders worldwide or (b) at least 500 persons who are not accredited investors worldwide. Also, the FPI has the total value of assets as of the end of the fiscal year exceeding $10 million; and (3) Public offering - Section 15(d): An FPI that has issued equity securities to the public in a registered offering even if it has currently not listed on any securities exchange 35

37 or crossed the size threshold of Section 12(g) also become subject to Section 15(d) of the Exchange Act (Bell, 2016; Eiger, Humphreys, and Tanenbaum, 2016; SEC, 2013). Under the preexisting rules, in order to terminate its registration of equity securities and suspend the reporting system, an issuer must first delist its securities under Section 12(b) registration by filing a Form 25 with the SEC. After filing the Form 25 for 10 days, a delisting becomes effective, and the issuer s reporting duties under Section 13(a) are suspended. Once delisting under Section 12(b), an issuer must consider whether it has reporting obligations under Section 12(g) and/or 15(d). If it does, the issuer must terminate its registration under Section 12(g) and suspend its reporting obligations under Section 15(d) by filing a Form 15. The key qualification for an FPI to file the Form 15 with the SEC is that it must meet the size threshold as stated in Section 12(g). The challenge of such size criteria faced by an FPI, especially the 300 U.S.-holder provision, is that the issuer must look through the record ownership of brokers, banks, dealers, and all other nominee accounts on a worldwide basis and counts the number of individual accounts of U.S. customers to determine the number of beneficial owners who are U.S. residents. In addition to this difficulty, a foreign issuer with Section 15(d) registration, who is generally an issuer that has conducted an SEC-registered offering, would find that it can simply suspend, and never terminate, its ongoing reporting obligations even if it has cut down the number of U.S. record holders to fewer than 300. Still, during the suspension period, these issuers must continue their annual verification that the number of U.S. record holders remains below 300. As long as the class of securities is outstanding, an issuer s reporting duties would automatically resume if at the end of any fiscal year the number of U.S. residents holding the issuer s securities exceed 300 (SEC, 2007). Out of concern that, due to the increased globalization of U.S. investor trading ac- 36

38 tivity, the former deregistration rules has increasingly become a major hindrance for an FPI to exit the Exchange Act reporting system even when there is very limited interest of U.S. investors in its U.S.-registered securities, and that such burdens and uncertainties associated with terminations may serve as disincentive to foreign firms accessing the U.S. public capital markets, on March 21, 2007, the Securities and Exchange Commission unanimously adopted the new Exchange Act Rule 12h-6 permitting a foreign private issuer of equity securities to terminate its Exchange Act registration and reporting obligations. The new rule also introduced a more achievable, alternative qualification benchmark relative average daily trading volume, in addition to the revised head-count measure. In particular, the new rule permits, for the first time, an FPI to terminate its registration of a class of its equity securities and the reporting obligations if (1) its U.S. average daily trading volume (ADTV) for a recent 12-month period is lower than 5% of the ADTV of that class of securities worldwide for the same period, or if its U.S. holders of record is less than 300, where the look through counting method used is modified. Rather than a worldwide search, the new rule allows firms to limit its U.S. holders counting to accounts located only in the U.S. and their jurisdictions; (2) it meets the Prior Exchange Act Reporting Condition: the FPI must have been an Exchange Act reporting firm for at least 12 months prior to the deregistration, filed and provided all reports required for this duration, and has filed at least one annual financial report; (3) it satisfies the Home Country Listing Condition: the issuers must maintain the listing of its subject class of equity securities on one or more exchanges which constitutes its primary trading market during the recent twelve-month period prior to the Form 15F filing; (4) it has contented the One-Year Dormancy Condition: the FPI must not have sold securities in the U.S. in a registered offering within the twelve-month period prior to 37

39 its termination from the Exchange Act. 3 ; and (5) the One-Year Ineligibility Period after Delisting or Termination of ADR Facility is met. An FPI must wait at least one year after delisting from any U.S. exchanges or terminating its ADR program before it may deregister a class of equity securities under the trading volume benchmark. 4 (SEC, 2007) Effective on June 4, 2007, Rule 12h-6 is cited as the first significant deregulation of U.S. disclosure requirement since the passage of the 1933/1934 Exchange and Securities Acts (Fernandes et al., 2010, p.130). While the SOX Act has raised the U.S. market listing standards to the very top level, Rule 12h-6, on the other hand, has withdrew the conditions of Exchange Act requirements governing when a foreign firm may exit its registration and the resulting reporting obligations so that the strictness of U.S. regulatory standard mandating the foreign listings tends to decline. Not only that the new rule ameliorates the termination process so that a foreign issuer could permanently escape its reporting obligations under the Exchange Act, the new rule also lower costs of compliance in connection with Exchange Act deregistration. Together, these benefits should over time reduce a deterrent to foreign firms accessing the U.S. capital markets. In effect, when comparing with the pre SOX period and the period after SOX prior to the enactment of the new rule (hereafter, PostSOX-PreRULE), I expect to see an improvement in likelihood of U.S. cross-listings after the new rule became effective (hereafter, PostRULE). This leads to the following hypothesis: H3a: Relative to the PreSOX and PostSOX-PreRULE periods, Rule 12h-6 would increase 3 Exceptions for securities transactions include securities sold in Rule 144A and Regulation S offerings, non-underwritten offerings by selling shareholders, offerings to employees, offerings due to the exercise of outstanding rights, warrants, or convertible securities, or offerings under a dividend or interest reinvestment plan. 4 The one-year waiting period does not apply if the U.S. ADTV of relevant class of equity securities, at the time the FPI delisted that class of equity securities or ceased its ADR facility, did not exceed 5% of the worldwide ADTV for the recent 12 months. 38

40 the U.S market attractiveness. Nevertheless, if the combination of stringent listing standards imposed by SOX and impracticability of escaping U.S. Exchange Act reporting obligations prior to the amendment of new deregistration rule had characterized the U.S. markets as an exclusive listing location for foreign firms with superior corporate governance qualities, the deregulation, which by its nature signifies the reduction in the degree of regulations over market, could demolish such exclusivity of U.S. markets which is fundamental of their value. To be specific, the U.S. markets could attract more listings from poor governance firms such as those residing in countries with weak legal institutions that once hesitated to enter the U.S. markets due to the deregistration issue after the amendment of the new deregistration rule. With a decline in superiority in regulatory standards of the U.S. securities markets controlling the market exiting channel and the influx of firms from weak governance countries, a group of foreign firms formerly attracted to the U.S. markets may struggle to differentiate themselves from those poor-rated firms, and would therefore find it more reasonable to pursue their cross-listings in somewhere else besides the U.S., such as London, where listing fees and compliance costs are cheaper. This leads to the following hypothesis: H3b: Relative to the PostSOX-PreRULE period, Rule 12h-6 would have made: ˆ the U.S. exchanges more attractive to firms residing in countries with poor corporate governance regimes; ˆ the U.K. Main Market more attractive to firms residing in countries with good corporate governance regimes while at the same time still remains attractive to 39

41 firms residing in countries with poor governance regimes. With the same similar rationale regarding the advantage of U.K. DR issues over the U.K. ordinary listings, as previously discussed in hypothesis H2b, I further hypothesize that: H3c: Relative to the PostSOX-PreRULE period, Rule 12h-6 would only pronounce the U.K. Main Market attractive among U.K. DR listings and would not have much impact on U.K. ordinary listings. 3. Data and variables 3.1. Sample Construction As this study intends to examine the economic consequence of the U.S. stock market regulations relating to FPIs on their listing decisions on the U.S. and U.K. markets, my sample therefore consists of two sets of sample firms. The first set is the U.S. cross-listings which only limits to foreign companies that list their shares, via ordinary listing, American Depositary Receipt (ADR) Level II and III, and New York Registered Shares, on the SEC regulated markets, including the NYSE, NASDAQ, and AMEX since only foreign firms listed their shares on these markets will primarily affect by SOX and the new Exchange Act Rule 12h-6. Despite being similarly regulated by the SEC, I did not include foreign firms listed on OTC Bulletin Board (OTCBB) market because of two reasons. First, the number of foreign firms listed on this market is very tiny. Second, the market return data which is used as one of the controlled variables in this study is unavailable for the OTCBB market. Foreign companies accessing the U.S. capital by means of a Rule 144a private 40

42 placement and other OTC issues via OTC Markets Group are also disregarded since the SEC registration requirements, many disclosure and reporting regimes, and regulatory bodies of the Securities Act as well as SOX requirements and the amendment in the SEC deregistration rule through Rule 12h-6 do not apply to these firms. I construct the list of companies with U.S. exchange listing between January 1, 1998 and December 31, This period of study would enable me to investigate the effect of the SOX Act of 2002 and the Rule12h-6 amendment in 2007 on foreign listing preference. Such length of time span allows me to separate the period of study into three subperiods with relatively equal time length. These subperiods including (1) PreSOX period is the period between 1998 and 2001 which is before an occurrence of any major SEC regulatory events. This period represents an uncontaminated market condition prior to any major regulatory events; (2) PostSOX-PreRULE period - spanning from 2002 to is the period after the enactment of SOX but prior to the amendment of Rule12h-6; and (3) PostRULE period - covering the period between 2007 and is the period after the introduction of the new Exchange Act Rule 12h-6. The way that SOX and Rule 12h-6 interacts makes this study challenging. Apparently, the SOX Act still remains effective when Rule 12h-6 was enacted; therefore, it is important that the PostSOX- PreRULE period must be separated from the period after the enactment of the new rule. In such way, the uncontaminated effect of Rule 12h-6 without the effect of SOX would be examined simply by subtracting the coefficients of PostRULE with the PostSOX- PreRULE dummy variables derived from the multinomial logistic regression. I gather the list of foreign companies cross-listed on the U.S. exchanges from two sources. First, I collect the list of firms issuing ADRs or New York Registered Shares - both active and inactive status - from the websites of four major banks, including 41

43 Citibank, the Bank of New York Mellon, JP Morgan, and Deutsche Bank. For ordinary listing, I obtain the list of firms from the exchanges websites and Center for Research in Security Prices (CRSP). The data set from CRSP helps complimenting the sample of foreign listing with both active and inactive foreign companies listed their shares on U.S. exchanges either by ordinary or ADR issues. The CRSP company share code number 12 represents a ordinary listing while share code number 30 and 31 represent an ADR listing. I manually cross-check and verify domicile countries of foreign firms, U.S. listing date, changes in U.S. listing status, including upgrading, downgrading, and delisting, and delisting date (if any), by consulting with the Form 20-F, 10-K, or 40-F from SEC filing as well as the companies websites. For any firm which originally lists on one major exchange and later move to another, I keep the listing date, exchange, and ADR program of first admission. I apply a number of selection criteria to the raw sample to ensure a more uniform set of sample data used in the analysis. First, I exclude a firm which originally accesses the U.S. through either a Rule 144A private placement or an OTC listing (or so-called ADR Level I) and later upgrade itself to ADR Level II or Level III since I am mainly interested in the effect of changes in U.S. regulations in initial profile of entrants at the point of listing, not the profile deviated from the initial-entry after some exposure to the U.S. markets. Second, to avoid any potential exogenous effect from other international listings, a firm that has foreign listings in other countries either prior to the U.S. listing or in parallel with the U.S. listing within 6 months will also be removed. Third, all sample firms must have data available on total assets, total sales, and market capitalization in either their first or second year post-listing. Fourth, I drop financial firms, investment funds, REITs, and trusts out from the sample since highly 42

44 leveraged and heavily regulated financial institutions can behave differently from firms in other industries. Lastly, firms incorporated in offshore tax havens, including Bermuda, Cayman Islands, Jersey, Marshall Islands, British Virgin Islands, Bahamas, U.S. Virgin Islands, the Netherlands Antilles, Isle of Man, Guernsey, and Falkland Islands are also removed. For the second set of my sample - the U.K. cross-listing - I construct this list from foreign firms with U.K. s LSE Main Market listing via ordinary listing or depositary receipt by advising the Official London Stock Exchange Main Market Historical Statistics data. I disregard foreign firms listing on the LSE s Alternative Investment Market (AIM) since listing requirements for trading on AIM are very minimal and poor compared to the listing standards of the LSE s Main Market or the U.S. stock exchanges. In particular, requirements such as prior trading, minimum market capitalization, minimum public float, transaction approval from prior shareholder, or admission documents to be prescreened by the UKLA or the exchange are not needed for listing on AIM. I obtain the listing dates of the LSE s Main Market cross-listed companies from Datastream and manually cross-checked with the LSE s website. Foreign firms that are cross-listed on both a U.S. exchange and a U.K. Main market within 6 months are excluded. To avoid a duplicate count, a firm will be considered a U.S. (U.K.) cross-listed company only if it has never been cross-listed on the U.K. (U.S.) market. Before applying all screening procedures, there are total 901 U.S cross-listed firms and 322 U.K. cross-listed firms over the sample period. Figure 1 provides a breakdown of my sample across the U.S. and U.K. markets and across regulatory event periods. The number of foreign listings on the U.S. exchanges and the U.K. Main Market over the period between 1998 and 2012 illustrates an interesting 43

45 Figure 1: Comparison of U.S. and U.K. new cross-listings across U.S. regulatory periods. This figure presents the comparison of new cross-listing in U.S. major exchanges versus U.K. Main Market in each period between 1998 and The PreSOX period covers the period before the enactment of SOX - the years from 1998 to The PostSOX-PreRULE period covers the period at and after the enactment of SOX until before Rule 12h-6 was adopted - the years from 2002 to The PostRULE period covers the period since the adoption of Rule 12h-6 - the years from 2007 to pattern which possibly associates with the changes in the U.S. foreign-listing-related regulations. The number of new U.S. cross-listings shows a declined trend after the SOX Act became effective. The total number of new foreign listings in the U.S. exchanges declined from 336 firms at the PreSOX to 263 firms at the PostSOX-PreRULE period which is about 22% decrease. Not surprisingly, this evidence has become a popular conventional wisdom in policy circles and in the financial press 5 that the U.S. has lost its competitiveness to the London Stock Exchange. However, if looking at the trend of the 5 See, for example, the Interim Report of the Committee on Capital Market Regulation (November30,2006) and several related news reports such as London Calling. Forbes (May8,2006); Wall- Street: What Went Wrong? The Economist (November25,2006); Is a US Listing Worth the Effort? Wall Street Journal (November28,2006); Is Wall Street Losing its Competitive Edge? Wall Street Journal (December2,2006); and In Call to Deregulate Business, A Global Twist Wall Street Journal (January26,2007) (Doidge et al., 2009a, p. 254). 44