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«International Finance Discussion Papers Number 877 September 2006 International Cross-listing, Firm Performance and Top Management Turnover: A Test ...»

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Board of Governors of the Federal Reserve System

International Finance Discussion Papers

Number 877

September 2006

International Cross-listing, Firm Performance and Top Management Turnover: A Test of the

Bonding Hypothesis

Ugur Lel and Darius P. Miller

NOTE: International Finance Discussion Papers are preliminary materials circulated to

stimulate discussion and critical comment. References to International Finance Discussion

Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IFDPs are available on the Web at www.federalreserve.gov/pubs/ifdp/. This paper can be downloaded without charge from Social Science Research Network electronic library at http://www.ssrn.com/.

International Cross-listing, Firm Performance and Top Management Turnover: A Test of the Bonding Hypothesis∗ Ugur Lel and Darius P. Miller∗∗ September 2006 Abstract We examine a primary outcome of corporate governance, the ability to identify and terminate poorly performing CEOs, to test the effectiveness of U.S. investor protections in improving the corporate governance of cross-listed firms. We find that firms from weak investor protection regimes that are cross-listed on a major U.S. exchange are more likely to terminate poorly performing CEOs than non-cross-listed firms. Cross-listings on exchanges that do not require the adoption of the most stringent investor protections (OTC, private placements and London listings) are not associated with a higher propensity to shed poorly performing CEOs.

Overall, our results provide direct support for the bonding hypothesis of Coffee (1999) and Stulz (1999), and suggest that the functional convergence of legal systems is indeed possible.

JEL classifications: G15, G30, G34, F30, M40, K22.

Keywords: Bonding hypothesis, CEO turnover, International cross listing, Corporate governance, Functional convergence.

* We would like to thank Mark Carey, Craig Doidge, Art Durnev, Nandini Gupta and seminar participants at the University of North Carolina GIA Conference, University of Oregon Empirical Corporate Finance Conference, the Federal Reserve Board, Southern Methodist University and University of Texas at Dallas for comments. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System. All errors are the sole responsibility of the authors.

** U. Lel: Division of International Finance, Federal Reserve Board, Washington, DC 20551, (202) 452-3168, ugur.lel@frb.gov. D. Miller: Edwin L. Cox School of Business, Southern Methodist University, Dallas TX, 75275-0333, (214) 768-4182, dpmiller@cox.smu.edu.

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Does cross-listing in the U.S. improve the corporate governance of foreign firms? The “Bonding Hypothesis” proposed by Coffee (1999, 2002) and Stulz (1999) predicts that after listing on a major U.S. stock exchange, foreign firms become subject to stringent U.S. investor protections which constrain insiders from expropriating minority shareholders. Because it has important implications for the effectiveness of U.S. laws and enforcement as well as the efficacy of market-based approaches in improving global corporate governance, the bonding hypothesis has attracted the recent attention of academics and practitioners alike.

To date, empirical support for the bonding hypothesis is principally drawn from the large literature that examines the economic consequences of cross-listing in the U.S.1 However, as Leuz (2006) notes, the evidence contained in many of these studies is fairly indirect, as it is difficult to attribute the economic consequences of cross-listing directly to the bonding hypothesis because many theories of cross-listing have similar economic predictions.2 Moreover, the validity of the bonding hypothesis has been called into question by a number of recent studies that document cross-listed firms’ lack of compliance with certain U.S. laws and the low number of enforcement actions by U.S. legal institutions (see, e.g., Siegel 2005 and Lang, Raedy and Wilson 2006). Therefore, whether U.S. securities laws and regulations improve the corporate governance of cross-listed firms is under debate as the nascent empirical evidence is predominantly indirect and yields mixed results.

In this paper, we pursue a different approach in testing the bonding hypothesis by examining a direct outcome of corporate governance: the propensity to replace poorly 1 Karolyi (1996, 2006) and Benos and Weisbach (2004) provide comprehensive surveys. We also discuss the literature in section 2 of this paper.

2 For further details on other theories that have been argued to generate similar predictions (e.g., market segmentation, investor recognition, increased liquidity, and better information) see the discussion in Doidge, Karolyi and Stulz (2004a) and Hail and Leuz (2004).

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protections, we should be able to observe specific outcomes that are consistent with improved corporate governance. We focus on the sensitivity of top executive turnover to performance since 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 (see, e.g., Kaplan 1994, Coffee 1999, Murphy 1999, Volpin 2002, Gibson 2003, DeFond and Hung 2004). We compile a database of 70,200 firm-year observations from 42 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. We find that the relation between CEO turnover and poor performance is stronger for cross-listed firms than non-cross-listed firms, and that the increased turnover to poor performance relation for cross-listed firms is concentrated in firms listed on major U.S. exchanges (e.g., level 2 and 3 ADRs). Firms that list in the over-thecounter market (level 1), conduct private placements (Rule 144a), or even list in London do not have a significantly different relation between CEO turnover and performance from noncross-listed firms. Further, we find that the increased relation between CEO turnover and poor performance for cross-listed firms is strongest in countries with weak investor protections. Overall, our results are consistent with the hypothesis that U.S. securities laws and regulations improve the corporate governance of cross-listed firms.

We also investigate several alternative explanations for our results, including the potential endogeneities that arise in a study of cross-listing and governance due to the non-random nature of the decision to list in the United States. For example, we investigate if our results are due to the notion that better governed firms are the ones that self-select to cross-list. To do so, we examine several specifications that measure the sensitivity of CEO turnover to performance for cross-listed firms prior to cross-listing. These tests show that the relation of

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period, which suggests that our results are not an artifact of the pre-cross-listed governance status of our sample firms. We also examine the potential impact of control changes around cross-listing on our results since cross-listed firms often sell control blocks during the listing year. We find our results are robust when these observations are omitted. Further, we examine if cross-listed firms terminate poorly performing management because they are able to access a more international pool of top management candidates by tracking the newly appointed CEOs’ previous work experience. We find that the vast majority continue to come from the domestic labor market, which suggests our results are not driven by labor market shifts.

We subject our tests to a battery of firm and county level robustness tests as well. We find our results are robust to country, industry and year fixed effects in addition to controlling for the possible entrenchment effects of concentrated ownership structures. Our findings are also robust when we exclude countries that contain the largest portion of our sample, remove observations surrounding the Asian financial crises and omit financial and regulated industries.

An important methodological note is that all of our analysis controls for the recently recognized difficulty in implementing and interpreting interaction effects in non-linear models (see, e.g., Ai and Norton, 2003).

Our results contribute to the literature in several ways. First, our findings add to the debate on whether U.S. securities laws and enforcement are effective in reaching non-U.S.

firms. Our results suggest that firms from weak investor protection regimes that are crosslisted on a major U.S. exchange have outcomes that are consistent with better corporate governance, findings that support the major predictions of the bonding hypothesis. Further, by showing that CEOs of cross-listed firms are more likely to face termination when firm performance is poor, our findings also contribute to the literature by documenting a specific

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documented in the literature.3 Our findings also have implications for the growing literature that examines how global corporate governance can be improved (see, e.g., LaPorta et al. 2000 and Coffee 2002). This research stems from the large number of studies that show that the economic consequences for firms located in countries with poor investor protections are severe.4 Given the economic impact of poor investor protections and the corresponding difficulty in changing a country’s legal structure (i.e., legal convergence), an important question is whether market based approaches (i.e., functional convergence), such as opting-in to a better legal system via crosslisting, can improve corporate governance. Our finding that cross-listing in the U.S. is associated with improved corporate governance is consistent with the hypothesis that the “functional convergence” of legal systems to a higher global standard is possible.

The remainder of the paper proceeds as follows. Section 2 discusses related literature.

Section 3 describes the data. Section 4 presents the research design. Section 5 shows the results and section 6 presents robustness tests. Section 7 concludes.

2. Related Literature The bonding hypothesis of Coffee (1999) and Stulz (1999) posits that firms cross-listed on a major U.S. stock exchange have better corporate governance than non-cross-listed firms from the same country, ceteris paribus, since cross-listed firms are subject to strong U.S. investor protections. These protections include mandated corporate disclosures, increased law See, for example, the discussion in Leuz (2006).

3 See for example, LLSV (1997, 1998) as well as the survey by Beck and Levine (2004).


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listed firms on U.S. exchanges must adhere to U.S. disclosure practices, which require them to reconcile their net income and shareholder’s equity to U.S. GAAP, disclose the identity of majority shareholders (10% or greater), and follow detailed procedures and disclosure during tender offers and going private transactions. Cross-listed firms are also subject to far reaching U.S. investor protection laws such as the Foreign Corrupt Practices Act and more recently, the Sarbanes Oxley Act. Cross-listed firms are subject to punishment by U.S. law enforcement, both by the SEC as well as private investor law suits. In addition, cross-listed firms are subject to increased scrutiny from intermediaries such as financial analysts and debt rating agencies.6 As a result, firms that cross-list bond themselves to a higher level of corporate governance, effectively “opting-in” to a more investor friendly legal system. In contrast, listing on the OTC market or conducting a private placement allows substantial exemptions from these laws and regulations.7 Specifically, the bonding hypothesis predicts that, ceteris paribus, (1) Cross-listed firms will have better corporate governance than non-cross-listed firms, (2) The difference in governance between cross-listed firms and non-cross-listed firms will be greatest in countries with weakest investor protections and (3) Cross-listings that require the most stringent U.S.

investor protections (i.e., on the NYSE, AMEX or NASDAQ) will have the largest differences in corporate governance. In this way, cross-listing in the U.S. represents a market-based approach to increased investor protection.

While in theory a U.S. cross-listing should lead to more effective corporate governance, the ability of cross-listing to serve as a bonding mechanism is under debate. On the one hand, 5 It is important to note that while firms may choose to cross-list for a variety of reasons, once they are listed they become subject to U.S. laws and regulations.

6 Coffee (2002) calls these intermediaries “financial watchdogs”.

7 For example, they are not required to register under the Exchange or Securities acts and are therefore exempt from most civil liability provisions and do not have to follow U.S. disclosure practices (Doidge 2004).

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evidence that is consistent with the bonding hypothesis. This line of research finds that crosslisted firms from weak investor protection countries have larger stock price reactions (Foerster and Karolyi 1999, Miller 1999), higher valuation (Mitton 2002, Doidge, Karolyi and Stulz 2004a), more scrutiny by financial analysts (Baker, Nofsinger and Weaver 2002, Lang, Lins and Miller 2003), lower cost of capital (Errunza and Miller 2000, Hail and Leuz 2004), better information environments (Bailey, Karolyi and Salva 2005), and more access to external finance (Reese and Weisbach 2002, Lins, Strickland and Zenner 2005). In addition, Doidge (2004) shows that cross-listed firms have lower voting premiums than non-cross-listed firms, which is consistent with cross-listing lowering the private benefits of control. However, ascribing the evidence contained in many of these studies directly to the bonding hypothesis is difficult given the well-known challenge in distinguishing among the various theories of crosslisting.

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