Opting Out of Good Governance

by C. Fritz Foley, Paul Goldsmith-Pinkham, Jonathan Greenstein & Eric Zwick

Overview — New disclosure rules of the Security and Exchange Commission (SEC) require that foreign firms listed on US exchanges articulate more clearly their compliance with exchange requirements. In this paper the authors study the extent to which cross-listed firms opt out of corporate governance rules, analyzing which firms opt out of US exchange requirements and the consequences of doing so. Opting out is quite common, with 80.2 percent of cross-listed firms opting out of at least one exchange corporate governance requirement. Firms that opt out appear to adopt weaker governance practices and have fewer independent directors. The decision to opt out appears to reflect the relative costs and benefits of this governance choice. The costs of complying are likely to be higher for insiders who might enjoy certain private benefits when following weak governance practices allowed in their home country. The benefits of complying are likely to be higher for firms that are attempting to raise capital and grow. Consistent with this tradeoff, the data show that firms based in countries with weak corporate governance are less likely to comply, and those that are based in such countries and are expanding and issuing equity are more likely to comply. Opting out of US exchange requirements also has consequences for how the market values cash holdings. For firms from countries with weak governance requirements, cash within the firm is worth significantly less if the firm opts out of more US exchange requirements. Overall, the paper provides insight about the costs and benefits of complying with stringent governance rules and also sheds light on the effect of governance requirements on valuation. Key concepts include:

There is considerable variation in the extent to which listed foreign firms agree to comply with the governance requirements of exchanges.
The decision to opt out reflects the relative costs and benefits of doing so.
Opting out of exchange requirements has consequences for how the market values cash holdings. For firms from countries with weak governance requirements, cash within the firm is worth significantly less if the firm opts out of more exchange requirements.
There may be a limit in the extent to which cross-listed firms can effectively borrow the US governance environment.

Author Abstract

Cross-listing on a U.S. exchange does not bond foreign firms to follow the corporate governance rules of that exchange. Hand-collected data show that 80% of cross-listed firms opt out of at least one exchange governance rule, instead committing to observe the rules of their home country. Relative to firms that comply, firms that opt out have weaker governance practices in that they have a smaller share of independent directors. The decision to opt out reflects the relative costs and benefits of doing so. Cross-listed firms opt out more when coming from countries with weak corporate governance rules, but if firms based in such countries are growing and have a need for external finance, they are more likely to comply. Finally, opting out affects the value of cash holdings. For cross-listed firms based in countries with weak governance rules, a dollar of cash held inside the firm is worth $1.52 if the firm fully complies with U.S. exchange rules but just $0.32 if it is non-compliant.