Today’s global financial markets offer companies and investors an enormous variety of choices across a range of economic prospects, political systems, and operating environments.
Even the smallest stock market investor can place his or her money around the world using vehicles ranging from index mutual funds to foreign stocks listed on the local exchange and beyond.
Corporations have a great deal of freedom to select legal, regulatory, and disclosure environments, in addition to where to operate, and how to finance their businesses.
The flexibility that investors and companies enjoy has spurred competitive markets in investment products, investment banking, management consulting, and advisory services. Beyond the businesses supplying these services, countries themselves often compete to attract real and portfolio investors and to offer a convenient and reliable place for headquarters and legal domicile.
Financial globalization is nothing new but the explosion of interest and activity makes the phenomenon ever more important to understand. Luckily, the quality and availability of data to study financial globalization has grown enormously in recent years and continues to improve.
This means that academics, practitioners, or anyone else with an interest in globalisation can organise some data, step back, and take a look at an interesting facet of financial globalisation.
As academics always on the lookout for an interesting case with broad implications to study, we decided to look at firms that select a particular legal, regulatory, and disclosure environment by incorporating in an offshore financial centre (OFC). International Monetary Fund publications offer a commonly-accepted definition of which countries are considered OFCs, and they range from tiny British island territories to larger jurisdictions like Hong Kong, Singapore, and Switzerland.
In our field of financial economics studied at business schools there is a long tradition of using data to study issues in corporate finance and a growing literature on international corporate finance, that is, what happens when a firm crosses a border in some sense. We are intrigued by the competing views on OFCs that are commonly expressed in the press, by experts, and by policymakers and legislators.
We went so far as to include the phrase “Naughty or Nice?” in the title of our project because opinion varies widely on what it means when a company from North America, Europe, Asia, or elsewhere incorporates in an OFC. The positive view is that places like Bermuda, the British Virgin Islands, and the Cayman Islands compete with larger capital markets and can offer low-cost, efficient legal, regulatory, and disclosure conditions that can enhance firm value and pressure other jurisdictions to improve.
The negative view is that incorporation in an OFC can enable mis-management and expropriation by self-serving corporate managers or controlling owners, in addition to tax evasion, accounting opacity and other questionable or illegal behavior. Furthermore, whether moving incorporation to an OFC enhances or detracts from corporate value can depend on the characteristics of the home country of the corporation, and there is a decent variety of home countries from which these companies originate.
While starting to collect the data for the study, we found several intriguing anecdotes almost immediately. Tyco International, a US- listed corporation, moved its legal domicile from Bermuda to Switzerland in 2009. The company’s 2009 10-K annual report states that the change in incorporation will enhance “our ability as a Swiss company to take advantage of the tax treaties between Switzerland and the United States.”
On the same page, “there continues to be negative publicity regarding, and criticism of, companies that conduct substantial business in the US but are domiciled abroad.”
The document goes on to say: “Because of differences between Swiss law and Bermuda law and differences between the governing documents of Swiss and Bermuda companies, it may not be possible to enforce court judgments obtained in the United States … in Switzerland.”
This single document encapsulates the idea that OFC incorporation could benefit shareholders with tax, insurance, and employee benefit advantages or could harm them by reducing their ability to control management or by damaging the company’s reputation.
If incorporation in an OFC is potentially harmful to non-controlling or minority shareholders, we then have to think about whether these investors should be protected in some way or whether it is their own responsibility to do their homework prior to investing and bear their responsibility for the investment choices they have made.
Related to this, we must also ponder whether big-economy governments have our interests in mind when they scrutinize what corporations are getting up to in OFCs or whether those governments are just trying to restrain competition from OFCs that serves to reduce big-economy government’s taxing and regulating powers.
Are the governments of the OFCs offering positive choices to businesses and investors around the world while enhancing their economic health and diversifying away from traditional sectors such as agriculture and tourism? Or are they simply exploiting cracks in the laws and regulations that govern global finance?
Another set of anecdotes involves problems with OFC-incorporated Chinese companies listed in US and other non-Chinese stock markets. Because the growth of China’s economy has outpaced the country’s legal, regulatory, and disclosure practices, OFCs may provide Chinese firms with a more secure and predictable legal system.
On the other hand, there have been a number of episodes concerning Chinese corporations that list on US stock exchanges and go on to experience severe management problems and scandals. Regulators explicitly mention the entry of problematic Chinese companies into US stock markets using reverse mergers, that is, using a US shell company to obtain an immediate US stock market listing.
Furthermore, some of the OFC-related structures employed by Chinese firms to list a holding company in the US appear to violate Chinese law by employing the “variable interest entity” form to evade Chinese restrictions on foreign ownership in certain industries.
Our next step was to determine the criteria for deciding whether the phenomenon is naughty or nice. As is typical of business school finance researchers, we decided to rely on the opinions of stock market investors as expressed by stock market prices and patterns in holding and trading stocks.
Of course, this assumes that stock markets produce sensible estimates of the true values of companies and update those estimates appropriately, and that the institutional investors whose holdings we study are rational, trustworthy, and effective professionals.
As the recent financial crises reminds us, the efficiency and rationality of the stock market and its participants cannot always be taken for granted, but at worst we get some useful values and opinions most of the time.
After a significant data collection effort, involving matching firms across several databases, addressing the issue of identifying home country versus legal domicile across a potential sample of tens of thousands of firms, and eliminating firms with insufficient stock market, income statement and balance sheet data, we were left with a sample of 1,372 firms.
These firms are incorporated in an OFC but are owned and operated elsewhere. Incorporations in OFC jurisdictions are heavily concentrated (more than 75 per cent) in two jurisdictions, Bermuda and the Cayman Islands. Firms from Hong Kong account for more than half of our sample, People’s Republic of China (PRC) firms about a fifth, and UK and US firms each less than 10 per cent. Hong Kong address firms tend to incorporate in Bermuda while China address firms tend to incorporate in the Cayman Islands.
A significant feature of these firms is relatively slow sales growth relative to other firms. We also constructed a control sample of 15,816 firms that are not located or domiciled in an OFC and have enough stock market data for us to study.
Finally, we focus our analysis of how the stock markets judge firms that choose to incorporate in an OFC around two questions. First, what is the valuation effect? We measure this with something called Tobin’s q.
This is the ratio of the market value of the company to the book value of the company. Imagine forming a company with an initial investment of US$100 and then assessing its value some years later. If the ratio of market value today divided by US$100 is significantly greater than one, the company creates value. If the ratio is less than one, it is the stock market’s judgment that the company destroys value.
To supplement our exploration of the Tobin’s q ratio, we also examine the stock market’s valuation of OFC and non-OFC firms through their initial public offering (IPO) performance. We explore the potential link between IPO performance, deal characteristics such as number of underwriters and fees, and the OFC status of the firm.
Second, how do institutional investors view OFC incorporated stocks? If these professional investors avoid these stocks, it suggests that there is something inherently value-destroying and unattractive about them.
Alternatively, professional investors may not single out OFC incorporated stocks from others in their portfolios, or may even seek them out if they confer valuable benefits.
When we answer the first question, valuation, we certainly see some evidence of the “naughty” story. For example, our valuation measure of market value to book value ratio is less than one-half for British Virgin Islands incorporated firms, and this low valuation extends to companies from the US, UK, Hong Kong, and China. However, after employing statistical controls for other firm characteristics, we find that incorporation in an OFC enhances value for firms from countries with low investor protection.
Moreover, we find that OFC firms with specific traits experience a larger valuation penalty from the stock market. In particular, we find that OFC firms, which are not growing significantly or are tightly controlled by insiders, show particularly low stock market valuation.
In contrast to our findings for the valuation ratio, it seems that the stock market unambiguously does not like IPOs of OFC-incorporated firms; they typically lose money from the offer price to the first day of trading.
It may be the case that the stock market does not mind an established, growing, well-governed company reincorporating in an OFC but penalises new companies that start their corporate life in an OFC. Therefore, our look at two dimensions of valuation suggests that there are both positives and negatives to OFC incorporation and the net effect depends on a company’s particular characteristics and circumstances.
To answer the second question, what is the institutional view, we begin with research records of US institutional investor holdings of US securities, that is, anything with a CUSIP number. This excludes, for example, a firm from Hong Kong that is incorporated in Bermuda and has no security traded in US stock markets. If we lump all institutions together, we find little clear evidence of either a preference or dislike for OFC incorporated firms compared to other firms.
When we break this data down by institutional characteristics, we see a few differences. One classification groups institutions into banks, corporate or private pension funds, independent investment advisor or mutual fund, insurance company, public pension funds, or university endowment.
Some institutions that are answerable to a specific clientele (public pension funds) are more averse to investing in OFC incorporated firms than institutions that invest on behalf of a large, diverse range of clients (mutual funds). Another classification groups institutions by horizon (quasi-index, dedicated or long -term investors, transient or short term) or style (large growth, large value, small growth, small value). Some institutions that trade actively seem to use OFC stocks to speculate on information or timing.
However, on balance, there is little if any evidence that US institutional investors systematically shun OFC incorporated stocks in any significant way.
Corporations face a variety of choices which can enhance or detract from the value their shareholders enjoy. When a company borrows, does it leverage its advantages or take dangerous risks that threaten the equity holders?
When a company issues executive stock options, does this motivate top management to work in the interests of the shareholders or does it impart a short-term mentality? When a company diversifies over many lines of business, does it benefit from synergies and risk reduction or does it protect managers from the consequences of their mistakes?
Similarly, it seems there is nothing inherently naughty or nice about the use of OFCs as legal domiciles by corporations. More fundamental characteristics such as the absence of growth opportunities or tight control by insiders seems to determine whether the ability to incorporate offshore is beneficial to shareholders or not.
In this respect, incorporation offshore seems similar to other corporate decisions.
A version of this paper first appeared in the Cayman Financial Review Second Quarter 2014, Issue 35.
Warren Bailey, Professor of Finance, Samuel Curtis Johnson Graduate School of Management, Cornell University, and Edith Liu, Assistant Professor, Charles H Dyson School of Applied Economics and Management, Cornell University