No Gains From Good Governance?: Why Foreign Companies Opt Out of Strict Regulatory Practices

The rise of electronic equity trading has nearly eliminated the transaction costs of establishing an international presence on foreign stock exchanges. Non-US companies that choose to cross-list on a US-based stock exchange, such as the NYSE, NASDAQ, or AMEX, have the option to adhere to the corporate governance requirements of these exchanges or to opt out and follow their home countries’ regulations. The existing literature presumes that it is in the interest of foreign firms to adhere to US governance requirements as a way to secure capital from outside investors, particularly when those firms are headquartered in countries with weak regulatory systems. However, in “Opting Out of Good Governance,” authors C. Fritz Foley, Paul Goldsmith-Pinkham, Jonathan Greenstein, and Eric Zwick find that over 80 percent of foreign firms choose to opt out of at least one US governance category and that firms headquartered in countries with weak governance structures are actually more likely to opt out of US exchange requirements. These results are even more surprising in light of a 2008 mandate from the US Securities and Exchange Commission (SEC) that requires foreign firms to explicitly disclose their governance practices.

The “legal bonding hypothesis” has dominated the literature on the behavior of cross-listed firms and argues that adopting the US regulatory structure is within a foreign firm’s best interest, particularly if the firm is from a country with weak corporate governance. Stricter mechanisms, such as requiring an independent board of directors or a third-party financial auditor, hold a company and majority shareholders within the company more accountable to outside investors. By adopting US governance practices, firms can “bond” themselves to the US’ stricter regulatory framework and signal to potential investors that outside investments will be protected from private expropriation. This bonding process allows firms from emerging markets, where regulation may not be as structured, to raise more outside capital and increase their perceived value as measured by the market value of a firm’s cash holdings. These benefits come at the expense of managers within the firm who are consequently less able to extract private benefits such as through having direct influence on compensation or stock issuance decisions. Therefore, managers of new and growing companies often decide to bond because the companies are not yet profitable enough to provide substantial private benefits.

Prior to 2008, foreign firms who chose to opt out were required to disclose any deviations from US governance practices, but they had discretion in how to present it. Often this information was intentionally buried in the footnotes of annual reports. However, in September 2008, the SEC amended Form 20-F, a mandatory document for all cross-listed firms, and added a section that requires foreign companies to explicitly state their governance practices. This change effectively raised a firm’s cost of opting out by increasing transparency to investors and accountability to the SEC.

While these increased costs theoretically should encourage more firms to adopt US regulatory practices, particularly if they are from countries with weak governance, Foley et al. find that a large majority of firms continue to opt out. The authors analyze six categories of governance practice and find that 80.2 percent of cross-listed firms opt out of at least one and 47.2 percent opt out of three or more. In addition, firms that opt out are more likely to be from weak governance countries.

Firms that choose to fully comply with US requirements are often smaller, and/or have significant growth opportunities. These companies have the most to gain from bonding because they can increase their outside sources of capital as well as their valuations. In particular, the authors find that bonding increases the value of a dollar within the firm to $1.52, while a company that opts out of all six categories drastically reduces its dollar value to $0.32. Firms that opt out and forgo this considerable valuation difference likely have the ability to extract significant private benefits under weaker governance structures in their home countries.

While there are both substantial value gains and increased costs of noncompliance, Foley et al. find that foreign firms continue to overwhelmingly opt out of some or all US corporate governance requirements. In light of the 2008 SEC ruling, this behavior is even more striking and highlights the need to refine the legal bonding hypothesis. While the cost-benefit framework of this theory appears to hold, bonding may not be in the best interests of foreign firms and the relative costs of doing so are substantial. In addition, the continued existence of cross-listed firms that opt out of all regulatory categories suggests that there are other factors at play in the cost-benefit decisions of these companies.

Article Source: C. Fritz Foley, Paul Goldsmith-Pinkham, Jonathan Greenstein & Eric Zwick, “Opting Out of Good Governance,” National Bureau of Economic Research, Working Paper, March 2014.

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