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| Title: |
Cross-listing in the USA, Corporate Governance, and CEO Turnover |
| Discipline: |
Finance |
| Date: |
08/2007 |
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Executive Summary:
A terrific debate has been waged for several years-whether a firm that cross-lists its stock in the United States and becomes subject to SEC regulation benefits in terms of corporate governance. One side argues that there is no hard evidence and that findings are indirect and tangential. Consequently, corporate governance can only be improved by improving legal investor protections in a country, which is harder to put into practice. In "International Cross-listing, Firm Performance and Top Management Turnover: A Test of the Bonding Hypothesis," Ugur Lel of the Federal Reserve Board and SMU Cox Finance Department Chair Darius Miller provide hard evidence that SEC regulation can improve the governance of non-U.S. firms.
Background
Prior studies point to the economic impact of the firm from South Africa, for example, cross-listing in the United States and gaining through a higher stock price, better stock market liquidity and more access to capital. While these studies argue that the market rewards firms for opting-in to the more stringent legal and regulatory regime in the United States, in essence adopting better corporate governance, more recent studies argue that these effects are transitory and may be due to other factors. Therefore, the jury has been out as to whether cross-listing in the United States can in fact "bond" the foreign firm to higher governance standards vis-à-vis U.S. securities laws and enforcement.
However, what is generally not debated is the research showing that countries with more stringent laws that protect investors with proper enforcement have enormous capital market benefits: Their markets are larger and deeper, with firms having better access to external financing. Miller explains, "All of these laws have benefits and outcomes for corporate governance. Firms can then grow faster and be valued higher. There is a big cost to companies located in countries with poor laws and investor protections in terms of corporate governance."
The findings of this research have implications for the debate about whether by changing the legal and institutional climate of a country and hence investor protections (legal convergence) a country's business environment can attract more business and investors. While policy makers often argue that we should strive for this ideal of legal convergence, it is extremely difficult to change entire legal systems and institutions of foreign countries. However, the ideas behind the bonding hypothesis may offer opportunities that would otherwise be closed; it offers that after listing on a major U.S. stock exchange, foreign firms become subject to stringent U.S. investor protections, which constrains insider trading and the like.
The bonding hypothesis reflects a market-based approach in improving global corporate governance. Functional convergence or market-based approaches such as opting-in to a better legal system via cross-listing offers a significant step for foreign firms to improve their corporate governance and not be viewed as a reflection of their home country legal or political system (and/or reputation). For firms with global aspirations that are perhaps handicapped by a poor investment climate, cross-listing offers a path toward greater opportunity and credibility.
The CEO Link
In this paper, the authors pursue a different approach in testing the bonding hypothesis by examining a direct outcome of corporate governance: the propensity to replace poorly performing CEOs. If cross-listing actually results in increased shareholder protections, specific outcomes should be observed that are consistent with improved corporate governance. An extensive body of international research shows that a necessary component of effective corporate governance is the ability to identify and replace poorly performing CEOs. Miller notes," CEO turnover conditional to poor performance is a necessary condition of good corporate governance. In other words, does a firm fire poorly performing CEOs? Bad CEOs are associated with poor stock price performance. Thus, a firm practicing good governance should terminate CEOs whose leadership surrounds stock price drops of consequence and duration."
When should we see a difference in CEO turnover between cross-listed and non cross-listed firms? "In London, there are relatively strong investor protections and good legal institutions compared to, say, Indonesia," Miller relays. "We would expect to see the biggest difference in cross-listed companies from countries that have weak governance. The effect of U.S. legal institutions really matters there. We find increased good governance (firing poorly performing CEOs) with firms from countries with weak investor protections, such as Columbia, Argentina, Peru, or Indonesia." Findings reveal that these firms get the governance boost as shown by their ability to shed CEOs, which they do once cross-listed. The authors subject their theory about CEO turnover and cross-listing to a battery of tests, and findings still prove robust.
Key Findings
The authors compiled a database of 70,976 firm-year observations from 47 countries from 1992 to 2003 to test the hypothesis that CEOs of cross-listed firms are more likely to face termination when firm performance is poor. The authors find the connection between CEO turnover and poor performance is stronger for cross-listed firms than non-cross-listed firms, and that the increased turnover for cross-listed firms is concentrated in firms listed on major U.S. exchanges. Firms that list in the over-the-counter market conduct private placements, or even list in London do not have a significantly different relation between CEO turnover and performance from non-cross-listed firms. Additionally, the increased connection between CEO turnover and poor performance for cross-listed firms is strongest in countries with weak investor protections.
The study also sheds light on the recent debate about fewer firms choosing to list on the NYSE versus the London Stock Exchange (LSE) post-Sarbanes-Oxley, since the study suggests it is like comparing apples and oranges. Miller adds, "The LSE doesn't have governance provisions as high as the NYSE as required by SEC regulation. Firms may be shying way from the U.S. markets not because of the increased costs, but because controlling shareholders and managers may want to protect themselves from tough governance standards which, in fact, would benefit shareholders in the end. Therefore, the hype and debate about firms shying away from listing in the United States is chasing the wrong tail so to speak. The debate about competition among these stock markets needs to be re-framed in terms of the benefits as well as the costs."
Overall, the authors' results are consistent with the hypothesis that U.S. securities laws and regulations improve the corporate governance of cross-listed firms. Is the bonding hypothesis true? Is a higher global standard achievable through "functional convergence" of legal systems? Their finding-that cross-listing in the U.S. is associated with improved corporate governance-helps affirm that functional convergence via market-based measures is possible.
Insights and Conclusion
The research illustrates one avenue foreign firms can take to improve corporate governance without having to change the legal systems in which they operate. U.S. laws are effective in reaching non-U.S. companies, with SEC regulation having positive effects and implications for cross-listed foreign firms.
"Even firms located in countries with poor governance mechanisms or weak legal institutions can credibly commit to better corporate governance and be valued higher by the market," Miller concludes. "Our research validates the idea that cross-listing in the United States is a measure that truly improves the corporate governance of firms." This can result in fundamental change in the way firms operate in terms of governance, and bring with it all the economic benefits shown in previous work by Miller and other academics.
"International Cross-listing, Firm Performance and Top Management Turnover: A Test of the Bonding Hypothesis" by Ugur Lel of the Federal Reserve Board and Finance Chair Darius Miller of SMU Cox is forthcoming in Journal of Finance.
Written by Jennifer Warren |
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