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«International Finance Discussion Papers Number 945 September 2008 Escape from New York: The market impact of SEC Rule 12h-6 Nuno Fernandes, Ugur Lel, ...»

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Board of Governors of the Federal Reserve System

International Finance Discussion Papers

Number 945

September 2008

Escape from New York: The market impact of SEC Rule 12h-6

Nuno Fernandes, Ugur Lel, and Darius P. Miller

NOTE: International Finance Discussion Papers are preliminary materials circulated to

stimulate discussion and critical comment. References in publications to International

Finance Discussion Papers (other than an acknowledgement 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to unpublished material) should be cleared with the author or authors.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/.

1 Escape from New York: The market impact of SEC Rule 12h-6 Nuno Fernandes*, Ugur Lel** and Darius P. Miller*** * Universidade Católica Portuguesa Palma de Cima 1649-023 Lisbon, Portugal nfernandes@fcee.ucp.pt ** Division of International Finance Federal Reserve Board Washington, DC 20551 (202) 452-3168 Ugur.lel@frb.gov *** Edwin L. Cox School of Business Southern Methodist University Dallas TX, 75275-0333 (214) 768-4182 dpmiller@cox.smu.edu Abstract We examine the stock market impact of SEC Rule 12h-6 which eased the ability of foreign firms to deregister with the SEC and as a result terminate their U.S. disclosure obligations under the 1934 Securities Exchange Act. We document that the market reacted negatively to the ability of firms from weak disclosure and governance countries to more easily opt out of the stringent U.S. reporting and legal environment. Our findings suggest that shareholders of non-U.S firms place significant value on U.S. securities regulations, especially when the home country investor protections are weak.

JEL Classification: G14, G15, G38 Keywords: International Finance, Deregulation, international cross-listing.

We especially thank Chester Spatt for alerting us to the existence of Rule 12h-6. We also thank Amy Edwards, Jennifer Marietta-Westberg of the SEC, Hemang Desai, Karl Lins and seminar participants at the European Finance Association (2008) conference, Queens University and the U.S. Securities Exchange Commission. 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 any other person associated with the Federal Reserve System.

2 Escape from New York: The market impact of SEC Rule 12h-6

By adopting these rule amendments today, we are remedying a problem that has been festering for decades. Our former deregistration rules, which required a nose-count of U.S. investors to determine if registration was required, was so beloved by our foreign brethren that it gave rise to such kindly monikers as "hotel California," or the "roach motel" or—one of my own creations—the "Venus flytrap." Surely none of us at the SEC want to perpetuate such ill-famed requirements.

-SEC Commissioner Paul S. Atkins, March 21st 2007 While SEC registration and the corresponding disclosure requirements are a defining feature of U.S. capital markets, the economic impact of these laws are currently under debate both theoretically and empirically.1 Perhaps nowhere is this more evident than in the controversy surrounding the effects of SEC registration and enforcement on foreign companies cross-listed on U.S. stock exchanges, since once becoming subject to U.S.

regulations, these laws make it difficult, if not impossible, for firms to deregister and therefore terminate their U.S. disclosure obligations. This disagreement has led both academics and policy makers alike to debate whether the recent decrease in U.S. crosslistings is evidence that the costs of U.S. regulations, which include the 2002 SarbanesOxley (SOX) Act, outweigh the benefits and consequently have rendered U.S. capital markets uncompetitive.2 In response to this debate, the SEC commissioner Paul S. Atkins announced on March 21st, 2007 the approval of Rule 12h-6. The new rule considerably eases the ability of foreign firms to deregister with the SEC and as a result terminate their U.S. disclosure 1 See Coffee (1984) and Healy and Palepu (2001) for reviews of this literature. More recent evidence is found in Bushee and Leuz (2005) and Greenstone, Oyer and Vissing-Jorgensen (2006).

2 See Berger, Li, and Wong (2005), Doidge, Karolyi and Stulz (2007a), Chaplinsky and Ramchand (2007), Hostak, Lys, and Yang (2006), Li (2006), Litvak (2007), Leuz, Triantis and Wang (2008), Piotroski and Srinivasan (2007), Smith (2006), and Woo (2006), Zingales (2007).

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requirements since the passage of the 1933/1934 Exchange and Securities Acts.3 In this paper, we add to the debate on the economic consequences of SEC registration and disclosure requirements by analyzing the market reaction to SEC Rule 12h-6.

Examining the market reaction to Rule 12h-6 provides a unique setting to test the economic consequences of U.S registration for foreign firms. We are able to exploit this market-wide shock in mandatory disclosure regulations to test how shareholders value U.S. registration of foreign firms. Our evidence provides a complement to previous empirical cross-listing research that employs the voluntary listing and delisting decisions of firms, where self-selection and joint hypothesis difficulties are well-known and often lead to debate on their interpretation (see, e.g., Doidge, Karolyi, and Stulz 2007a).

Further, because of the difficulty of deregistering before Rule 12h-6, prior research on voluntary deregistration was forced to study the relatively few atypical firms that not only self-selected to deregister, but could actually meet the stringent deregistering requirement.

As our experiment design also enables us to measure the economic consequences of SEC registration cross-sectionally, we are able to analyze specific factors argued in the literature to influence both costs (e.g., compliance costs) and benefits (e.g., improved investor protections). Further, since not all cross-listed firms are currently registered with the SEC (e.g., OTC and Rule 144a ADRs), our setting allows us to examine how a holdout sample of non-registered firms reacts to deregulation and therefore control for any confounding effects of contemporaneous unobserved firm shocks.

3 Mandatory increases in disclosure regulations have also been extremely rare since the passage of the 1933/1934 Exchange and Securities Acts (e.g., the 1964 Amendments, the OTC Eligibility Rule of 1999 and the Sarbanes-Oxley Act of 2002).

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announcement. Our event study results document that the market reacted negatively to the ability of firms from weak investor protection regimes to easily opt out of the stringent U.S. reporting and legal environment. For example, we find that the market reaction is negative for firms located in countries with poor disclosure environments as well as for firms from countries with Civil law legal origin and with low levels of judicial efficiency. The results are economically significant, with the mean (median) firm losing 0.57% (0.91%) of market value ($112 million ($32 million) respectively) on the announcement that they now have the option to revert to their less stringent home country disclosure requirements.

In contrast, we find that the market reaction was insignificant for firms located in countries with strong investor protections. Therefore, our results suggest that shareholders place the highest value on U.S. disclosure requirements when the levels of disclosure and investor protection are poor in the home country. In contrast to the country level disclosure and investor protection results, we find much weaker evidence that proxies for compliance costs or financing needs explain the market reaction. Finally, we also find that the negative abnormal returns are concentrated in firms that are currently complying with SEC disclosure requirements (e.g., level II or III ADRs), rather than cross-listed firms exempted from registration requirements (OTC and 144a ADRs). This suggests the economic impact of the rule is concentrated in firms currently subject to SEC registration. Overall, the results support the hypothesis that U.S. disclosure and investor protection laws have significant economic benefits, especially for cross-listed firms from poor investor protection regimes.

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Consistent with prior research, we find that prior to 12h-6, deregistrations by non-U.S.

firms were relatively rare events. However, in the 8 months since the rule took effect, 80 firms have announced their intention to deregister from U.S. exchanges, the largest yearly total in history. Further, while one of the stated rationales of the new rule was to increase the attractiveness of U.S. capital markets, we find that the period since the rule took effect is the first time in history that the number of deregistrations is larger than the number of new registrations. Therefore, our results suggest that not only did 12h-6 have significant economic consequences, it also materially affected the deregistration and listing behavior of foreign firms.

We also subject our analysis to a battery of robustness tests. We find our results are robust when we exclude Canadian firms, the country that contains the largest portion of our sample. We also exclude penny stocks and find that their potential microstructure effects do not drive our results. Further, we verify that our event window was not anticipated by examining alternative announcement dates as well as potential confounding announcements surrounding the event. Also, our findings are robust to firm level governance controls. Finally, our results are consistent across SUR, OLS and Sefcik and Thompson (1986) estimation methods.

Our study makes several contributions to the literature. First, we provide, to the best of knowledge, the first empirical evidence, foreign or domestic, on the economic impact of disclosure deregulation. Previous research on the economic impact of U.S. disclosure regulation includes studies on the effects of the imposition of the 1933 Securities act (e.g, Stigler 1964, Friend and Herman 1964, Robbins and Werner 1964, Benston 1969 and

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is heavily debated (Coffee 1984). More recent work by Greenstone et al. (2006) finds increases in disclosure mandated by the 1964 Securities Act amendments increased firm value. Bushee and Leuz (2005) study the 1999 “eligibility rule” which required domestic firms trading on the Over-The-Counter Bulletin Board to comply with the 1934 Act. Our results add to this literature by providing evidence on how U.S. disclosure deregulation impacts foreign firms. In this way, we contribute to the empirical research on the costs and benefits of disclosure regulation in general, a literature that Healy and Palepu (2001) note is surprisingly sparse.4 We also contribute to the literature that examines the impact of U.S. laws and regulations on cross-listed firms. While a large number of studies find significant economic benefits for cross-listed firms, a more recent literature is debating whether the costs of U.S. regulations, including the 2002 SOX Act, outweigh the benefits.5 For example, Marosi and Massoud (2008) find that deregisterings prior to Rule 12h-6 were motivated by post-SOX compliance costs rather than governance benefits of U.S.

registration. However, this evidence is based on the atypical firms that could meet the stringent pre 12h-6 deregistering requirements, which are very small and poorly performing firms predominately owned by insiders. 6 In contrast, our experiment design 4 In contrast, there is a large literature that examines the impact of mandated accounting standards changes (see Bushee and Leuz 2005 and citations contained therein).

5 Karolyi (1998, 2006) and Benos and Weisbach (2004) provide comprehensive surveys of the earlier studies.

6 The average deregistering firm in Marosi and Massoud (2008) is less than 1% the size of the average registered foreign firm (based on total assets). While they do not model the stock price reaction crosssectionally or consider the role of disclosure, they find the 148 deregistering announcements over 1990 to 2006 are accompanied by a negative market reaction which decreases post-SOX. In contrast, Hostak, Lys and Yang (2006) argue there were even fewer deregistrations (only 75) during the pre 12h-6 period and find that governance related factors, rather than compliance costs, play an role in the deregistering decision for these small, poorly performing, low trading volume firms.

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to draw (often different) inferences about the economic consequences of U.S. registering from the population of cross-listed firms, and therefore we are able to avoid many of the sample selection and endogeneity limitations inherent in the pre-Rule 12h-6 time period.

Our paper provides evidence on how the market values a reduction in mandated disclosure, and therefore we are able to gain insights into the economic consequences of one of the most important aspects of international cross-listing.7 The remainder of the paper proceeds as follows. Section I reviews the Rule 12h-6.

Section II describes the data. Section III presents the event study methodology and results on the market reaction to the announcement of Rule 12h-6. Section IV presents multivariate regression results. Section V presents robustness tests. Section VI presents firms’ delisting and deregistration frequency around the new Rule. Section VII concludes.

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On March 21st, 2007, the SEC approved its new rules for deregistration by foreign private issuers, taking effect June 4th, 2007. These rules amend the existing regulations that govern when a foreign private issuer (FPI) may terminate the registration of a class of its equity or debt securities and the corresponding obligation to file reports as required by the U.S. Securities and Exchange Act of 1934.

A. Existing Registration and Deregistration Regulations 7 See Lang, Lins and Miller (2003, 2004) and Lang, Raedy and Wilson (2006) for reviews on the disclosure implications of cross-listing.

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