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Motivations Behind Cross-Listing in International Stock Exchanges

Abstract


The world’s capital markets have been greatly influenced by globalization since the 1980’s. The trends in globalization have influenced the integration of capital markets to make shares accessible to foreign investors in foreign markets. Cross-listing is how companies ensure they are listed in foreign countries to make their shares accessible to foreign investors. Investment barriers have been the main obstacle to global trading and foreign market access hence increased integration was intended to reduce the need for firms to cross-list however it is clear that cross-listing is still popular among firms around the world. Globalization and technological advancement has eased cross-border capital flow through information exchange and accessibility thus opening a gateway for capital markets to compete on a global scale. This paper will analyse the motivating factors that make cross-listing a favourable subject to firms using the US market as the main point of reference. It will then look at the regulatory implications and challenges of extraterritorial reach of enforcement bodies.


Theoretical review of cross-listing

Foreign listing can be generally advantageous. The results of a survey of foreign companies in the US shows that companies that list their shares in the US find the abnormal increase in returns are in tandem with investor recognition as well as greater liquidity. This shows the importance of foreign firms getting access to external capital markets which provide inaccessible options that are not available in domestic markets. It is then important to realize the important role these markets play in the flow of liquidity globally especially in the context of firms from developing countries that have weak markets and domestic institutions.

Competition is the very essence of any market and the same applies to capital markets. Mergers and affiliations have been a popular trend in security markets, case example being Euronext with a capitalization of $ 2.4 trillion, was born after a merger of the Paris, Amsterdam, and Brussels exchange. Since ‘liquidity attracts liquidity’, the consolidation process will result in markets offering greater liquidity, lower trading costs and an advancement in technology. This ‘winner takes-all’ trend will eventually lead to a decrease in the number of markets with a decrease in liquidity for smaller markets as the larger markets aim to take up large portions of liquidity. This notion seems practical but premature because it is also important to take into consideration the motives and practices of firms that cross-list and those that do not to understand the objectives and limitations of the issuers.


Corporate governance plays an important role in determining what Capital structure a company will adopt. There are two main theories of capital structure that companies adopt to obtaining funds. The trade-off theory seeks to ‘achieve the target debt ratio that corresponds to the point where the marginal benefits equal the marginal costs of debt’ and the Pecking Order Theory which states ‘variations in debt are not motivated by the wish to achieve the target debt ratio, but are the consequence of the accumulated funding needs that are not covered by internal finance, and in this situation firms prefer to turn to debt rather than external equity.’ These two theories suggest that capital structure is defined by various characteristics including inter alia: profitability, size, age, growth opportunities, risk, asset structure, non-debt tax shields. The governance structure of a firm determines its corporate objective which in turn moulds its capital structure to obtain capital. Cross-listing provides a viable option for firms to meet their objectives.

Corporate governance structures of firms also influence the regulatory structures of the markets they trade in. Some firms have dispersed ownership which aim to maximize share price, these firms are predominant in the US markets whereas some firms adopt concentrated ownership where firms have a long-term goal of stability and performance, these firms are mainly located in Europe. Different markets accommodate different types of firms. Some markets may choose transparency with stringent listing requirements to accommodate dispersed ownership whereas other markets may insist on lower costs and minimal disclosure of transactions to accommodate firms that have concentrated ownership.


Motivations of cross-listing

There are various theories that explain the reasons why firms seek to list their shares in foreign markets.


Market fragmentation hypothesis

Market fragmentation is undoubtedly the most debated reasons firms choose to cross-list. The phenomenon is caused by various factors, mainly heavy taxes, and regulatory restriction on investment. Firms choose to list their shares in foreign markets to simply overcome the international investment barriers. Domestic investors expect increased earnings from securities listed in foreign markets than their domestic market. Cross-listing gives firms the opportunity to make their stocks available to a wide range of investors which increases their shareholder reach and this facilitates risk sharing which eventually results in a lower cost of equity capital and high stock price.

Stapleton and Subrahmanyan were among the first people to suggest that cross-listing is a way for firms to reduce the effect of segmented markets. In their paper, they also identified two types of segmentation. The first type being a restriction on certain individuals investing in certain securities which results in segmentation in international capital markets. The second type is characterized by a difference in tax rates and the cost of capital.Firms will often opt to list their shares in markets that have a low cost of capital and low tax rates.

Studies have shown that foreign firms that list their shares in the US markets benefit from a reduced cost of capital. This is particularly beneficial to firms from developing countries who experience a lower cost of capital as compared to those from developed countries. Foreign firms that decide to go public in US markets also experience a rise in stock price during the announcement of the cross-listing.This is mainly attributed to the use of American deposit receipts (ADR) which are negotiable certificates issued by a depository bank and are held by a trustee in the home market of a non-US company.

ADRs come in four types consisting of three for public offerings and one for private placement. Level I ADR’s can be traded over-the-counter in the US and some markets outside the US. Level II ADRs are traded on NYSE, NASQAD or AMEX markets and are used by firms seeking liquidity and investor recognition. Level III ADRs are used to raise new equity capital in IPOs and can trade on the NASQAD, AMEX, or NYSE. Level II and III ADRs need to be registered through Section 13 and 14 of the Securities exchange Act 1934 and must meet listing requirements in the respective markets.

Some commentators have challenged the market segmentation theory. Dodge et al observe that cross-listing firms that are already integrated in the US market seem to equally benefit from the trend. This contradicts the notion that cross-listing is supposed to cure the lack of integration. Realistically, the effect of the two should not be similar. They further conclude that the number of listings has increased and that due to global integration, there should be no need to cross-list as the barriers that motivated it in the first place should be reduced or non-existent. They further support Lee’s findings by concluding that if there is an increase in the number of countries cross-listing, the abnormal return that coincides with announcement of cross listing should fall.

This argument makes sense but the motivations and circumstances are not set in stone, it is important to consider that other factors are yet to be identified and can probably account for the abnormal results.

The announcement of a public offering signals that a firm is willing to turn to equity and this is usually the last resort after a firm has exhausted its debt options. This is a signal to foreign investors that investment barriers have been dropped and access to foreign stock is available. With globalization and market integration on the rise, with time cross-listing should reduce. Although the current trend shows otherwise, it is clear there are other motivations to cross-listing that makes it a viable option to firms.


Liquidity hypothesis


A market that has a high liquidity volume has a positive effect on the share prices listed on it. In a comparative view, the shares of a company listed in a foreign developed market should have a higher value than unlisted shares in their respective domestic market. The increase in liquidity for firms is essential as it leads to a lower cost of capital that will facilitate an opportunity to raise future capital thus, this is one of the reason some firms have opted to list their shares in foreign markets.

Cost of equity capital is determined by the net return required by investors, as well as the costs of the net return and the cost of equity capital that companies face. It is a consideration of the of the shareholder returns including dividends, transaction costs and taxes and the amount of taxes and costs paid associated with listing. These include inter alia underwriting fees and annual listing fees.

The liquidity of a market and the cost of equity capital are strong considerations that firms take when choosing a market to list in. Currently, NYSE, Nasqad, Euronext, Deutsche Boerse and the London stock exchange are the largest markets respectively representing 58% of the world capitalization.Different markets have different costs, example being the underwriting fees which can be considered the highest in the US compared to the European Markets.

The position on the effect of cross listing on liquidity varies, one position taken by Dodd is that cross-listing encourages competition which results in an increase in the number of trading hours and traders. This eventually reduces the bid-ask to spread and stimulates an increase in trading volume. He then concludes that cross-listing increases stock liquidity and this lowers the cost of equity capital and results in high share price.

The position from emerging markets is somehow different, some scholars have argued that cross-listing does not lead to an increase in liquidity or trading volume. In this case liquidity tends to decrease and price volatility increases. Furthermore, in cases where there are excess returns, the result is due to series that were open to foreign investors prior to listing. The conclusion drawn from this is that developed markets that have a large volume of liquidity offer a better option in terms of trading volume. These markets have a lower cost of equity and its then understandable why firms seeking listing opt for the developed markets due to the benefits they provide.

This is shown in the results of a study by the Smith and Sofianos“trading volume after listing in both the domestic and foreign markets are greater than in the domestic market before listing.” Their results found the value of trading after cross-listing in the US was a 42 percent and a 24 percent increase in the home markets.

Additionally, in one of the most important surveys conducted in this topic, Foerstar and Karolyi conducted a survey on firms from Canada that decided to cross-list in markets in the US and found that there was an increase in trading volume in the domestic and US markets due to a decrease in trading costs.

In conclusion, empirical evidence has shown that firms that decide to cross-list in developed markets experience an increase in trading volume that eventually leads to an increase in stock valuation whereas firms that decide to cross-list in emerging markets experience little or no increase in stock value. This justifies why firms opt to choose developed markets to cross-list in search of equity capital.


Bonding hypothesis

Cross-listing in foreign developed exchanges such as the NYSE exposes a firm to (I) increased enforcement by the Securities and exchange commission(SEC) (II) a demanding litigation environment, and (III) enhanced disclosure and consideration to the Generally Accepted Accounting Principles (GAAP). The transition from domestic jurisdictions to a developed market such as the NYSE is motivated by respect of minority shareholder rights, this is called the bonding hypothesis. Bonding can be divided into legal and reputational bonding. Legal bonding involves compliance of rules set by exchanges and regulations imposed by market regulators. Reputational bonding involves the relation and perception of the cross-listing firm by the investment community.

These requirements often have strict legal and disclosure requirements that firms must comply with that demand a revision of a firm’s corporate governance standards to ensure investor protection. Before listing in the NYSE firms will have to (I)appoint at least two external directors in its board, (II) establish and maintain an audit committee of external directors and, (III) organize appropriate quorum for shareholder meetings. The same are not imposed by the markets themselves, rather they originate from the securities and exchange commission disclosure requirements and from public and private enforcement.Compliance results in the dilution of the controlling shareholder base and power, which will prevent one sided policy decision making on the direction of the company.

The essence of this movement is that managers take into consideration investor protection by trading private benefits for an increase in the share price of the firm. A change in shareholder protection will lead to a decrease in private benefits but an increase in the value of the firm’s public shares due to a restriction on wealth transfer out of current cash flows and it will lead to an increase in cashflows by enabling managers to carry out projects that have a positive net value.

Thus, ‘a cross-listing on an exchange with stricter legal and disclosure requirements compared to those of the home market is a way to “bond” the firm to better corporate governance practices, which limits the ability of managers and controlling shareholders to take excessive private benefits. It is a declaration by the managers of the firm to the shareholders and the market that they respect the wishes of their shareholders by ensuring the firm policies will lead to an increase in shareholder wealth through appropriate means.

Reputational bonding is an expression of a firm’s characteristics to the world. Firms that are listed in American markets are more to likely bond themselves by building on their reputation. This reputation comes with a sense of security and in some cases, it has been shown that insiders will not engage in asset taking during an emerging crisis as long as firms have bonded themselves through a listed ADR. Furthermore, in the event of illegal activities, the SEC and US law enforcement should prosecute wrongdoers through federal security laws to protect investors.

Although the US legal system provides an avenue for investors to take class action law suits. SEC rarely prosecutes firms that are cross-listed as compared to US firms in the event of illegal activities. And in the event when judges have accepted class actions including foreign shareholders, they have often ruled on forum non conviniens. Regardless of this, any manager seeking to list in the US market should be aware of the inherent risk to litigation and this could be a deterrent.

Firms that offer a sense of investment security will subsequently gain a positive reputation in their home markets. This will create a prestigious image and serve as marketing tool for firms to increase their share prices by attracting investors. A study showed that firms that were registered with ADR’s had a significantly higher stock rating during the 1997-1998 financial crisis in Asia with higher returns of 10.8 percent. This shows that firms registered with ADRs are transparent and this decreases the chances of expropriation taking place during a financial crisis due to the high levels of disclosure that coincide with ADRs.

Reputational bonding was best summarized in a study by Fanto and Karmel when they found that most investors found ‘US listing made their company elite both in the international investment community and among home country investors. This belief probably stemmed from the fact that US listings signify a public presence in the world's largest capital market and compliance with the world's most difficult disclosure and listing requirements.Perhaps if a foreign company complies with US disclosure standards, it distinguishes itself from similarly situated companies that have notmade such disclosure.’


Information asymmetry hypothesis

Firms that wish to cross-list or go public for the first time must meet the disclosure requirements in their home and respective markets. This disclosure is not only initial but on a periodical basis. The amount of information provided by a firm is a direct reflection of its commitment to direct disclosure and this will mean less monitoring costs for investors & the management.The motivation behind this is that foreign markets usually have higher disclosure standards than the domestic markets and the reasoning behind this is that it will lead to a greater flow of accessible information in the market. This is because firms that cross-list in markets such as the US are under the supervision of watchdogs such as the SEC and analysts.

One motivation for investors is that cross-listing in these transparent markets obliges the managers to adopt a corporate governance structure that bonds a firm to greater transparency and this will reduce private benefits and fraudulent activities.Another motivation is that access to these markets will reduce information asymmetry between investors and insiders which will make it harder for insider trading by evening the playing field.Information is a very important aspect in this field. Despite this, there is very little direct evidence on the effect of an information environment on the firm.This is because a direct test of the information environment is not possible.Some studies that have been conducted have used price volatility and volume reaction to earnings announcement to test the information environment.Analysts come in and try to fill this void.The reasoning is that when a market has sufficient analysts who provide accurate forecasts, it is a signal of a rich information environment. Aside from disclosure requirements, cross-listing puts pressure on firms to provide information to analysts and this leads to increased coverage by investment analysts which reduces the cost of researching on firms listed. An increase in investment base has a direct relation to analyst’s activity as investors are attracted to firms that are the subject of analyst’s interest.

In summation, the present literature and empirical evidence shows that information disclosure and the analysis of information by analysts provides a positive information environment which leads to an increase in stock valuation and liquidity.


Regulatory implications of cross listing

In the regulatory context, Coffee (2007) discerned that the level of regulation and the subsequent enforcement intensity is what explains the difference in the cost of capital in different jurisdictions (emphasis between common law and civil law) and the valuation premium of foreign firms cross-listing in the US. He is of the view that high enforcement is a double-edged sword on one side, it enhances share value for firms that cross-list in markets with high enforcement intensity and, on the other side it acts as a deterrent to foreign issuers who do not wish to cross-list in high enforcement jurisdictions.

Coffee (2002) also observed that NYSE and Nasqad have rules that restrict listed companies from taking any action that affects the voting rights of existing shareholder’s ordinary shares. These rules are intended to protect minority shareholders however under NYSE, Nasqad and Amex rules foreign issuers are exempt from these restrictions.He also found that the UK Listing Authority adopts a similar degree of disparity between domestic companies and foreign issuers with foreign issuers being regulated “less rigorously” than domestic companies.

Since these exchanges are business run enterprises it is unlikely that they will enforce rules that will deter the wide range of clientele coming from jurisdictions that have different governance structures from trading in their exchanges in the current competitive global climate. It is then understandable why Markets like the NYSE would waive some governance standards for non-US listed companies.

Demutualization of exchanges has also raised questions on the efficient regulation of exchanges.

Demutualization of the major exchanges around the world can be explained by two reasons, competition and technology. Competition forced exchanges to shift from monopoly owned enterprises to public owned for-profit organizations. The rationale was exchanges will be run in an efficient manner that will “maximize the residual value” shareholders which will in turn serve the interests of its owners. Technological advancement meant that the old system would not provide flexibility to adapt to the fast-changing competitive environment.

On the face of it demutualization appears to be advantageous, however questions have been raised on the possibility of conflicts of interest of exchanges working as market operators and regulators. Regardless, studies have shown that demutualization is a useful tool even in emerging economies and that it leads to better performance.

The Sarbanes-Oxley Act (2002) was introduced in the aftermath of financial scandals by companies such as worldComm and Enron. The Act introduced reforms that were meant to curb fraudulent practices and restore shareholder confidence.

The Act has been attributed as one of the reasons that firms have been delisting from the US markets due to even higher disclosure requirements and higher cost of compliance. Some provision such as Section 103, 404 had a direct impact on foreign listed companies in the US as they demanded the appointment of independent auditors and the maintenance of an internal financial reporting structures respectively. These changes mean that cross-listed firms must increase the amount paid in compliance fees. Because of this, some firms have considered if the pros outweigh the cons and it has subsequently resulted in some firms delisting from US exchanges.Some commentators have opined that the NYSE has become less competitive than the LSE and evidence of this is the growing numbers of new listings in the LSE.

Jurisdiction poses a problem for monitoring and enforcement of regulation of cross-listed companies because most of the assets and registered offices are in the home country of the listed company. Jurisprudence from US courts have shown the difficulty of adjudicating misfeasance cases by foreign issuers.

 In the Supreme Court case of Morrison v National bank of Australia case against the defendants who were listed in the United states with ADRs but were trading in the Australian stock exchange. The court had to decide whether 10(b) of the Securities Exchange Act 1934 had extraterritorial reach. “The court held that Rule 10b–5, the regulation under which petitioners have brought suit, was promulgated under §10(b), and does not extend beyond conduct encompassed by §10(b)’s prohibition. Therefore, if §10(b) is not extraterritorial, neither is Rule 10b–5. On its face, §10(b) contains nothing to suggest it applies abroad.”

The decision in the Morrison case shows the challenges regulators face in enforcing legislation in extraterritorial jurisdictions. To curb this problem, the securities regulating bodies of the major exchanges in the world are members of the international Organization of Securities Commissions (IOSCO) and signatories of its Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information (MMoU).

 This platform though not binding provides regulators an avenue for cooperation and exchange of information. Resource can however be taken through bilateral treaties on recognition of foreign Judgements for enforcement of concluded cases relating to securities between different jurisdictions.


Conclusion

Increased global integration has undoubtedly decreased investment barriers over the years but firms still opt to cross-list in other jurisdictions. Different firms have different motivations and it is likely there are other motivations that have not been discussed in literature. The integration of markets cannot overcome the geographical, political, and cultural boundaries of different countries. It can only provide easy access to foreign markets because at the end of the day, countries will always have borders. The number of cross-listing firms is likely to gradually decrease with time however this rate will not be drastic. Cross -listing will likely endure the test of time but not in a prominent level.


Managing Partner

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