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Incorporation in Offshore Financial Centers: Naughty or Nice?

Incorporation in Offshore Financial Centers: Naughty or Nice?. Warren Bailey and Edith X. Liu Cornell University 26 th April 2014. Pompano Beach, Southampton, Bermuda: a relaxing holiday. Carrot Bay, Tortola, British Virgin Islands: what else goes on here?.

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Incorporation in Offshore Financial Centers: Naughty or Nice?

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  1. Incorporation in Offshore Financial Centers: Naughty or Nice? Warren Bailey and Edith X. Liu Cornell University 26th April 2014

  2. Pompano Beach, Southampton, Bermuda: a relaxing holiday

  3. Carrot Bay, Tortola, British Virgin Islands: what else goes on here?

  4. 1. Does a firm’s environment matter? Legal, regulatory, and disclosure environment relates to firm value and quality • Daines (2001): US firms incorporated in Delaware have higher value and are more likely takeover targets • Doidge, Karolyi, and Stulz (2004): cross listing of a non US firm in the US is associated with higher Tobin’s q Do such decisions benefit ordinary shareholders, or do they enable expropriation by managers and insiders?

  5. Does a firm’s environment matter? The choice of where to incorporate can affect other corporate decisions and, thus, affect value • Wald and Long (2007): leverage decisions of US firms depend on which US state firm incorporates in • Poison pill studies: Malatesta and Walking (1988) and Comment and Schwert (1995)

  6. Does a firm’s environment matter? • Some jurisdictions attract incorporations with a high quality value-enhancing legal regime • Other jurisdictions offer weak legal, regulatory, and disclosure standards that allow management or controlling owners to benefit at the expense of other owners • Whether or not off-shore incorporation improves a firm’s value and quality depends on environment in both the home country and the offshore legal host jurisdiction

  7. Does a firm’s environment matter? Cross-listing literature: impact of listing in a stronger legal and regulatory environment Our paper: • do some firms choose a lax environment to benefit managers and insiders at the expense of ordinary shareholders and other stakeholders? • or do offshore financial centers (OFCs) offer a low-cost, efficient environment that enhances firm value and pressures other jurisdictions to improve?

  8. 2. What is an Offshore Financial Center (OFC)? Zoromé (2007): “…’the banking system, acting as financial entrepôt, acquires substantial external accounts beyond those associated with economic activity in the country concerned,’ or countries where the ratio of deposit banks’ external assets to exports of goods and services is significantly higher than the world average.”

  9. What is an Offshore Financial Center (OFC)? “…a jurisdiction in which its international investment position assets, including as resident all entities that have legal domicile in that jurisdiction, are close to or more than 50 percent of GDP and in absolute terms more than $1 billion.” Example: Bermuda 2003 • net export of financial services = 42% of GDP • portfolio assets > 100 times GDP

  10. What is an Offshore Financial Center (OFC)? 2003 (net export of financial services) / GDP > two standard deviations above the mean: • Bahrain, Barbados, Bermuda, Cayman Islands, Guernsey, Hong Kong, Isle of Man, Jersey, Latvia, Luxembourg, Mauritius, Netherlands Antilles, Panama, Singapore, Switzerland, Uruguay, and Vanuatu Offshore banks hold about 1/8 of global bank assets

  11. What is an Offshore Financial Center (OFC)? • Switzerland, Channel Islands: early European OFCs • New Jersey 1889, until Governor Woodrow Wilson reversed, driving activity to Delaware • First in Western Hemisphere: Bahamas 1936 • OFC activities contribute significantly to government revenue and jobs, diversify agriculture and tourism • BVI 2001: 15% of jobs, 55% of government revenue

  12. An aside: OFCs as Tax Havens • Hines and Rice (1994): OFC affiliates account for about 20% of all US FDI, motivated by low tax rates • Desai, Foley, and Hines (2006): detail tax advantages • Dyreng and Lindsey (2009): significant tax saving for US firms that use at least one OFC • Current events: Google, Starbucks, others Taxation is not the focus of our study but reminds us that OFCs can offer benefits to corporations

  13. Positive purposes of OFCs Morriss (2010): OFCs • lower the cost of insurance and employee health for US corporations • allow many multinationals to make full use of international tax treaties • provide Chinese investors with a more secure and predictable legal system • encourage healthy competition among jurisdictions

  14. Negative uses of OFCs Morriss (2010): anecdotes of • local government corruption • narcotics trade • financial fraud • tax evasion Bad image…

  15. A 2012 U.S. presidential candidate avoiding income tax? Bank accounts in the Cayman Islands (legal under US law)

  16. China’s elite hiding wealth? Coleherne Court , South Kensington 2002年4月，薄瓜瓜居住的房屋被一家名为“黄金地图”的公司以约合720万元的价格购买。该公司位于避税天堂英属维京群岛。在英国金融时报上，房屋的原所有人讲述了交易的经过：“一名法国男子提出买房，并以黄金地图公司的名义在香港办理了手续。”

  17. Do OFC laws and regulations help top managers to steal? CEO Dennis Kozlowski was convicted in 2005 of looting tens of millions of dollars from Bermuda-incorporated Tyco International. Extravagant home furnishings featured prominently in press coverage, in particular a $6000 shower curtain. He currently “resides” at the Mid-State Correctional Facility in upstate New York.

  18. Our issue: Incorporation in OFCs Example: the British Virgin Islands • no disclosure requirements • minimal numbers of directors and shareholders • anonymity on most dimensions • ease of transfer of corporate assets • tax exemptions

  19. Naughty or Nice? • OECD Financial Action Task Force 2000, and 2001 declared many OFCs “non cooperative” for issues such as money laundering, weak law or regulation, obstructing international law enforcement, and inadequate allocation of resources to law and regulation • International organizations have continued to monitor, offer assistance, and apply pressure to OFCs to upgrade the quality of their legal, regulatory, and disclosure environments (International Monetary Fund, 2006, 2008)

  20. Naughty or Nice? Scant academic evidence on incorporation in OFCs • OFCs are associated with poorer-quality corporate disclosure (Durnev, Li, and Magnan, 2010) • OFCs are associated with weaker returns at merger and acquisition events (Col and Errunza, 2013) • OFCs were heavily involved in the US securitization boom which fed the recent financial crisis (Lane and Milesi-Ferretti, 2010).

  21. Naughty or Nice? An example Hong Kong’s Jardine group of companies re-organized in Bermuda in 1984. Bermuda law was thought to enhance the Keswick family’s control of the group • Protect the company once control of HK returned to China in 1997? • Increase the power of the Keswick family and other insiders at the expense of minority shareholders?

  22. Naughty or Nice: Ambiguous? Bar-Gill, Barzuza, and Bebchuk (2006) on reincorporation • improves the welfare of shareholders on some dimensions (such as Delaware’s court system or an OFC’s tax system) • also frees insiders to expropriate more • competition limits revenue an OFC can extract Thus we can have “naughty” and “nice” simultaneously

  23. Naughty or Nice: Ambiguous? US listed Tyco International moved legal domicile from Bermuda to Switzerland in 2009. From 10-K mentions: • “…our ability as a Swiss company to take advantage of the tax treaties between Switzerland and the US” • “…negative publicity regarding, and criticism of, companies that conduct substantial business in the U.S. but are domiciled abroad..” • “it may not be possible to enforce court judgments obtained in the United States…in Switzerland”

  24. Naughty or Nice?: PRC firms Concerns and problems with OFC-incorporated Chinese companies listed in US and other non PRC markets • Growth in China’s economy has outpaced legal, regulatory, and disclosure practices • Chinese corporations often suffer management problems and scandals (see, for example, Hung, Wong, and Zhang, 2011)

  25. Naughty or Nice?: PRC firms • US regulators mention problematic Chinese companies listing with reverse mergers (Public Company Accounting Oversight Board, 2011; SEC, 2011) • Ang, Jiang, and Wu (2012): listing by reverse merger, greater earnings management, and weaker corporate governance predict greater likelihood of scandal. Many recent US listings from China incorporate in OFCs, particularly the Cayman Islands

  26. Outline of our paper Does incorporation in an OFC improve or weaken firm value and quality? • Value (Tobin’s q, IPO return) of firms incorporated in OFCs relative to other firms • Characteristics that predict firm incorporates in OFC • Do institutional investors distinguish OFC and non OFC incorporated firms?

  27. 3.1 Model Doidge, Karolyi, and Stulz (2004) • whether a non US firm lists on a US stock market relates to investor protection in the US exceeding investor protection at home, ρUS > ρ • trade-off: firm grows faster raising capital and dealing with stakeholders under US legal and regulatory system, but constrains controlling shareholders expropriating minority shareholders.

  28. Model • Adapt their model to the case where investor protection for incorporation at home, ρhome, exceeds investor protection when incorporated in an OFC, ρofc • Controlling shareholders are entitled to fraction, k, of the cash flow, C, of the firm and select fraction, f, of firm cash flow to expropriate beyond kC • Expropriation imposes cost quadratic in f and linear in ρ • OFC incorporation foregoes growth opportunities z but gains cost efficiencies and tax benefits α

  29. Model Controlling shareholders gain if incorporated at home: k[(C+z) – f (C+z) – ½ b f2 ρhome(C+z)] + f(C+z) (1) b > 0. In brackets is firm cash flow - expropriation – cost of expropriation. f(C+z), is benefit from expropriation. Controlling shareholders gain if incorporated in OFC: k[(C+ α) – f(C+ α) – ½ b f2 ρofc(C+ α)] + f(C+ α) (2)

  30. Model Maximize over f and substitute f* back in. Controlling shareholders gain if incorporated at home: k(C+z) + ½ [(1-k)2/bρhomek](C+z) (3) Gain if incorporated in an OFC: K(C+ α) + ½ [(1-k)2/bρofck](C+ α) (4)

  31. Model Let θ = parameter (1/2)(1-k)2/bk. Then controlling shareholders choose to incorporate in OFC if gain exceeds that for incorporation at home: K(C+z) + (θ/ρhome)(C+z) < K(C+ α) + (θ/ρofc)(C+α) (5a) The left-hand side shows gain from greater growth (home) while right-hand side shows gain from greater expropriation (OFC)

  32. Model Doidge, Karolyi, and Stulz (2004) comparative statics • growth opportunities discourage OFC incorporation • expropriation opportunities (that is, ρhome - ρofc) encourage OFC incorporation What is the effect on the value of the firm, that is, the value perceived by minority shareholders?

  33. Model Cash flow if incorporated at home with “optimized” f : (C+z)(1 – [(θ/ρhome)(1+k)/(k(1-k)] (6a) if incorporated in an OFC: (C+α)(1 – [(θ/ρofc)(1+k)/(k(1-k)] (6b) Therefore, OFC incorporated firms can sell at a discount to firms incorporated at home, discount is increasing in z and (ρhome - ρofc), but could be premium if α is large

  34. Model We need not constrain ρhome > ρofc • imagine circumstances where an OFC offers a simple, low-cost, effective environment, in effect, ρofc > ρhome • less expropriation when a firm incorporates in the OFC (C+z)(1 – [(ϴ/ρhome)(1+k)/(k(1-k)] < (C+ α)[1 – (ϴ/ρofc)(1+k)/(k(1-k))] (8)

  35. Model Doidge, Karolyi, and Stulz (2007) extend Doidge, Karolyi, and Stulz (2004) model • add firm level governance, q, to country governance, ρ • ρ + q enters the deadweight cost of expropriation • cost of firm governance is increasing in its level, mq2 • cost to raising equity from outside investors

  36. Model Doidge, Karolyi, and Stulz (2007) comparative statics • firm level governance, q, is less likely to be changed if cost of implementation, m, is high • firm level governance can increase to compensate for decrease in country level governance We specify several testable hypotheses based on the theoretical ideas we have summarized…

  37. 3.1 Testable hypotheses Begin with a simple null: • H0: Incorporation in an OFC is irrelevant and, after controlling for firm characteristics, there is no valuation difference between firms from non OFC countries that incorporate in an OFC versus firms from a non OFC country that incorporate in their own country.

  38. Testable hypotheses Next, suppose OFCs offer a weaker legal and regulatory environment (ρofc < ρhome): • H1: Incorporation in an OFC allows controlling shareholders to avoid home country legal and regulatory discipline and expropriate more benefits from minority shareholders.

  39. Testable hypotheses Specific implications of H1: • H1a: Firms that choose to incorporate in an OFC have weaker governance and lower growth opportunities than other firms • H1b: Firm value is lower for OFC incorporated firms. Firm value declines when a firm incorporates in an OFC and increases when it moves incorporation from an OFC

  40. Testable hypotheses • H1c: The effects predicted by H1a and H1b are heightened for firms located in high quality environments that choose to incorporate in an OFC, for firms that incorporate in an OFC with a particularly weak legal and regulatory regime

  41. Testable hypotheses Alternatively, suppose OFCs offer a superior legal and regulatory environment (ρofc > ρhome): • H2: Incorporation in an OFC offers a firm a more efficient legal and regulatory environment that enhances firm value. H2 also implies additional hypotheses H2a, H2b, and H2c that parallel H1a, H1b, and H1c.

  42. Testable hypotheses Finally we view the irrelevance (H0), value destruction (H1), and value creation (H2) theories from the point of view of institutional investors • H3: The signs of the valuation effects predicted by H0, H1, and H2 are mirrored in patterns in the holdings of institutional investors.

  43. 3.2.1 Data: Firms and Characteristics Combine: • all active, dead, and suspended Datastream firms • all active firms on adr.com and adrbnymellon.com • all firms on CompactD Worldscope CD-ROMs from January 1992 to July 2006 • all firms on Compustat North America from January 1980 to January 2012

  44. 3.2.1 Data: Firms and Characteristics • Country of incorporation: first two digits of the ISIN identifier (underlying firm for ADRs) or, for Compustat NA , the “fic” variable • Country of address: “Nation” in Datastream, “loc” in Compustat NA, and “Country” in ADR websites and Worldscope CompactD Each company is associated with a country of incorporation and a country of address (given merging, many dups)

  45. 3.2.1 Data: Firms and Characteristics OFC incorporated firms sample • country of incorporation among OFCs listed in IMF (2006). Total 7,990 firms • Exclude all firms with country of address = country of incorporation (that is, OFC locals). Total 2,819 firms • Exclude firms with key financial series missing (Tobin’s q computation) or less than 4 years of consecutive sales (need to compute sales growth). Total 1,372 firms.

  46. 3.2.1 Data: Firms and Characteristics Control firms sample • all Datastream firms with address in one of the countries of address among firms in the OFC sample • eliminate firms with country of incorporation different from country of address • eliminate firms on financial data criteria outlined previously for OFC sample firms. Total 15,816 firms.

  47. 3.2.1 Data: Firms and Characteristics Firm specific characteristics • annual balance sheet and income statement variables (constrained by availability on Datastream) • Tobin’s q is computed for each firm-year • Capital raising (SDC) • US 13F institutional holdings

  48. 3.2.2 Country characteristics • legal origin (expanded with www.indexmundi.com), indexes of anti-director rights, judicial efficiency, expropriation risk, and accounting standards from La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) • real GDP, population, stock market capitalization, and developed versus emerging status, Milken Institute capital access index • updated anti director rights indexes of Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2008) with values for China and Russia inserted from other authors’ work

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