A recent study by HBS assistant professor Jordan Siegel tests whether foreign firms can leapfrog their countries' weak legal institutions by listing equities in New York and voluntarily abiding by U.S. securities law.
The study, which will be published in a forthcoming issue of the Journal of Financial Economics, suggests that reputational bonding better explains the success and failure of cross-listings than legal bonding. This is largely due to the fact that the Securities and Exchange Commission, for a number of reasons, has rarely been effective in enforcing the law against any U.S.-listed foreign firm.
Siegel collects evidence from a core sample of Mexican firms to show that some insiders from foreign-listed firms exploit this lax enforcement and run off with the firm's assets with impunity, while others learn to reap the market rewards of a positive reputation for good corporate governance. But in both cases regulatory oversight has little to do with the outcome. Professor Siegel recently participated in this Q&A.
Ann Cullen: You make the case that the SEC has been unable to be the world's enforcement agency and has consequently been ineffective in prosecuting cross-listed firms that violate the law. What can be done to rectify this situation? Doesn't this undercut one of the supposedly main benefits of listing in this country?
Jordan Siegel: The SEC faces two primary challenges. One is that it is still severely resource constrained and has not often acted in even the most serious governance cases filed in U.S. courts by private shareholders against foreign cross-listed firms. Second, even if the SEC had the resources required to fully investigate the potentially false disclosures and statements by foreign cross-listed firms, the SEC lacks a sufficient foreign presence to gather the evidence necessary for a successful prosecution in U.S. federal court.
Firms with reputational assets have a strong positive incentive to continue to live up to those reputations.
The SEC has historically had no foreign field offices, and it relies on the goodwill and daily cooperation of foreign regulators to meet the evidentiary standards of U.S. federal courts. Oftentimes, relying on foreign regulators for evidence gathering means that enforcement is very difficult.
Q: You report that 15 percent of all firms listed on the New York Stock Exchange are domiciled abroad. Is there the possibility of a diminished market for these issues if the SEC's enforcement record was better known? Given your findings on cross-listed firms, should investors be more cautious investing in American Depositary Receipts (ADR)?
A: Yes, you are correct that the majority of the investing public is likely still unaware of the weak enforcement history. Even in the rare case where the SEC has been successful in punishing a cross-listed firm, the foreign insider responsible for the transgressions has often walked away without any punishment whatsoever.
My ongoing research examines whether revelations about weak enforcement history have hurt the market for cross-listing. The evidence from my two papers would suggest that investors should place greater trust in those cross-listed firms that have built up a reputation for good governance through bad economic times. Firms with reputational assets have a strong positive incentive to continue to live up to those reputations. Firms with reputational assets are able to secure privileged access to outside finance as a result of their reputation. They may also enjoy other market benefits from their reputation as well (such as with customers and business partners).
Q: Could you elaborate more on this point that firms might choose to follow the rules when they cross-list on a U.S. exchange not because they're concerned about repercussions, but because of the business reputational assets they gain by doing so?
A: Clearly, with even a small probability of enforcement, many foreign insiders will respect the law. But the prospect of a reputational asset may be an even stronger incentive for producing law-abiding behavior. My study has shown through a carefully controlled natural experiment that those Mexican insiders that built a reputation for good governance through the Mexico crisis of 1994-95 enjoyed privileged access to finance over the course of the 1990s. This positive reputation can be identified even after controlling for the underlying quality of these firms. The firms with insiders who engaged in serious governance violations were effectively cut off from the global capital markets and lost their future access to outside finance.
A more reliable system for disclosure could allow far more firms from emerging economies to tap into the global capital markets.
Although this market-based enforcement system does not have the same number of sticks at its disposal as the legal system would have, it does have more carrots to use for rewarding good governance behavior.
Q: You mention that "reputational bonding" could be further strengthened if the U.S. information environment were stronger. What would need to occur to make the information environment stronger?
A: Many exceptions have been granted to foreign firms when they fill out their U.S. disclosures. There is too much missing information, and the disclosure requirements for foreign cross-listed firms should be brought up fully to the standards of U.S. firms. The SEC should also be granted the resources to more systematically verify the accuracy of these disclosures by foreign cross-listed firms. If the information were more reliable, investors could use the information to better differentiate among the cross-listed firms based on underlying quality. A more reliable system for disclosure could allow far more firms from emerging economies to tap into the global capital markets.
Q: How could the immaturity of the legal and regulatory environment in emerging markets impact the development of their local exchanges?
A: Evidence from the literature has clearly shown that many local exchanges in emerging markets are suffering for the lack of strong legal and regulatory institutions to protect minority investors. When investors lose their money, and when they see no opportunity for legal protection, they tend to stop investing in locally listed firms. Many local exchanges around the world are struggling to grow, and some are even contracting to a significant degree. Weak legal and regulatory institutions deserve a major part of the blame for this unfortunate phenomenon.