Incorporation in Offshore
Financial Centers:
Naughty or Nice?
Warren Bailey and Edith X. Liu
Cornell University
26th April 2014
1
Pompano Beach, Southampton, Bermuda: a relaxing holiday
2
Carrot Bay, Tortola, British Virgin Islands: what else goes on here?
3
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?
4
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)
5
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
6
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?
7
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.”
8
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
9
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
10
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
11
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
12
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
13
Negative uses of OFCs
Morriss (2010): anecdotes of
• local government corruption
• narcotics trade
• financial fraud
• tax evasion
Bad image…
14
A 2012 U.S. presidential
candidate avoiding income tax?
Bank accounts in the Cayman Islands (legal under US law)
15
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。”
16
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.
17
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
18
19
20
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)
21
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).
22
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?
23
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
24
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”
25
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)
26
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
27
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?
28
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.
29
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
30
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)
31
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)
32
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)
33
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?
34
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
35
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)
36
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
37
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…
38
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.
39
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.
40
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
41
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
42
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.
43
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.
44
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
45
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)
46
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.
47
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.
48
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
49
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
50
3.2.2 Country characteristics
Problems
• many sample firms come from China but classic La
Porta et al indexes do not cover China
• Many OFC countries are not covered by these indexes
because they are tiny or because they are not fully
independent countries (examples: Channel Islands,
British Crown Dependencies)
51
3.2.2 Country characteristics
Solution: take some similar series from other data bases
• Djankov, LaPorta, Lopez-de-Silanes, and Shleifer
(2003): days to collect on a bounced check or to evict a
tenant for nonpayment of rent; law and order index
covers more countries
• World Bank’s Worldwide Governance Indicators
•
World Bank’s ‘‘Doing Business’’ indicators
52
3.3 Methodology
1. Regress Tobin’s q (or IPO return or institutional holdings)
on firm and home country characteristics and an OFC
dummy variable:
qit = α0 + α1Dofc,it + β’xit + δ’cit + εit
(9)
• Dofc,it = 1 if firm i is incorporated in an OFC in year t
• xit is vector of company characteristics
• cit is vector of country characteristics
53
3.3 Methodology
2. Extend (8) with two-stage Heckman procedure to control
for self-selection or endogeneity bias (Doidge, Karolyi,
and Stulz, 2004; Bailey, Karolyi, and Salva, 2006)
• First stage is Probit regression. Dependent variable is
OFC dummy, independent variables are country
characteristics and firm characteristics
• Second stage regresses Tobin’s q on OFC dummy,
country and firm characteristics as in specification (8),
plus inverse Mills ratio from the first stage
54
3.3 Methodology
3. A variation on (8) adds slope dummy terms of
explanatory variables times the OFC dummy to
decompose any OFC valuation discount or premium
measured by the slope
4. Summary statistics on value and holdings series
55
4.1 Overview of the data
Table 1: country of incorporation versus country of address
for OFC-incorporated sample firms
• Panel A: firms (1372)
• Country of incorporation is heavily concentrated:
Bermuda + Cayman Islands > 75%, BVI < 5%
• Country of address,: Hong Kong > 50%, PRC ≈ 20%, UK
and US each < 10%
56
4.1 Overview of the data
Patterns in country of address and incorporation
• Hong Kong address firms often choose Bermuda
• PRC address firms often choose Cayman Islands
• UK address firms often choose nearby British Crown
Dependencies
•
Greek firms often choose Marshall Islands
57
Table 1, Panel A
58
4.1 Overview of the data
Patterns in exchange listings (Panels B and C)
• listing on formal US exchanges is unusual except for
PRC firms incorporated in Cayman Islands and BVI
• several hundred firms headquartered in Hong Kong but
incorporated in Bermuda or the Cayman Islands are also
listed in Hong Kong
• huge number of HK and PRC address firms which are
OFC incorporated and listed on Germany’s exchanges
59
Table 1, Panel B
60
Table 1, Panel C
61
4.1 Overview of the data
Table 2 Panel A: average Tobin’s q by country of
incorporation and country of address (both OFC sample
and controls)
• Number of observations reduced: exclude firm with total
assets < 10 million USD to avoid problems computing
Tobin’s q , also exclude extreme 1% tails
• 918 OFC, 7876 control firms
Substantial differences across the rows and columns ...
62
4.1 Overview of the data
• OFC incorporated HK firms have higher q than HK
control firms, except BVI incorporated which display
average q of only 0.4770
• OFC incorporated PRC firms have lower q than PRC
control Chinese firms, with a particularly low average,
0.4543, for BVI incorporated
• Relatively low q for BVI incorporated UK and US firms,
though the absolute number of UK and US firms is much
smaller than HK and PRC
63
Table 2, Panel A
64
4.1 Overview of the data
Table 2 Panel B: other firm characteristics
• Relative to control firms, OFC incorporated firms have
lower average 3-year sales growth (supports H1a)
• Low growth plus size similar to controls suggests “cash
cows” are more likely to incorporate in an OFC
65
Table 2, Panel B
66
4.2 Tobin’s q
Table 3: single-stage equation (9)
• Specification (1): constant and OFC dummy yields and
strong negative coefficient of -0.0948 (t-statistic = -11.64)
but a very small r-squared (supports H1)
• add year and industry fixed effects, specification (2),
coefficient on OFC dummy is even more negative and
statistically significant, -0.1241 (t-statistic = -15.39), rsquared rises to over 11%
67
4.2 Tobin’s q
• Specification (3) adds country characteristics. OFC
dummy remains significantly negative (-0.1303, t = 15.51).
• Specifications (4) and (5) add proxies for growth. Slope
on OFC dummy remains negative. Insider holdings
detracts from firm value.
68
4.2 Tobin’s q
• Does very large Tobin’s q (2.8680 in Panel A of Table 2)
of Chinese control firms tilt the regression estimates?
• Specifications 6 and 7 include only China and HK
address firms. Slope on OFC dummy is significantly
positive when capex and insider holdings included.
Validates H2 for certain countries.
On balance, Table 3 suggests that incorporation in an OFC
detracts from value (H1) but not for all countries (H2).
69
Table 3, Panel A
70
Table 3, Panel B
• Negative (?) valuation effect with cross listing
• Seems to come from China/HK firms
71
72
4.2 Tobin’s q
Table 4: two stage Heckman procedure
• Probit show growing firms (capex) more likely to
incorporate in OFCs. Not consistent with H1, H1a. More
insider holdings incorporates in OFCs (H1).
• Second stage shows negative association between OFC
dummy and Tobin’s q , though weaker
• slope on inverse Mill’s ratio suggests “treatment effects”
are not important
73
Table 4
74
4.2 Tobin’s q
Table 5: decompose slope on OFC dummy with slope
dummy or interactive terms
• positive slope on OFC dummy (0.65, t test = 7 or 8)
indicate nothing fundamentally bad about OFC
incorporation
• High growth (capex) firms, poorly governed (insider
holdings) firms, firms from good environment destroy
value incorporationg in OFC
• Cross listing plus OFC incorporation is particularly bad
75
Table 5
76
4.2 Reincorporation events
Supplemental Table: value changes around reincorporation
•
the number of such events is small, ≈ 100
• enormous volatility in Tobin’s q, indicating very volatile
book versus market values from year to year
• for book value of equity > 0 (?!?), Tobin’s q declines from
2.65 two years before to 1.25 two years after
• small numbers of observations for individual OFCs
77
78
4.3 IPOs
• another facet of firm value is price of an initial public
offering relative to its market price once it begins trading
• for this draft of the paper, briefly examine some statistics
on IPOs of China-address firms
•
standard SDC data
79
4.3 IPOs
Table 6 Panel A: IPO summary statistics
• Median one year IPO return 10.61% across both OFC
and control firms
• Bermuda (35 firms): -10.71%
• BVI (11 firms): -40.60%, large underwriting fees
• Cayman Islands (87 firms): -5.79%
80
Table 6, Panel A
81
Table 6 Panel B: China/HK firms only
• Tiny sample suggests OFC incorporation is bad
82
Table 4
Table 7: single-stage equation to explain IPO returns
• Significantly negative slopes on OFC dummy
83
4.5 Institutional Holdings
• Table 8: single-stage equation to explain US institutional
holdings
• No clear pattern in the slope on OFC dummy
• Institutions dislike high insider holdings and poor country
disclosure quality, like firm originating in high quality
investor protection regime
• In Panel B, US institutions prefer US cross listed firms.
84
Table 8, Panel A
85
Table 8, Panel B
86
4.5 Institutional Holdings
Table 9: US institutional holdings by institution type,
institution horizon, investment style (Bushee 1998, 2001)
Length of holding, fraction of stock held
• Panel A: preferences differ across institution types,
especially public pension fund versus independent
investment advisors/mutual funds
• Panel A: public pension funds seem somewhat averse to
OFC incorporated firms
87
Table 9, Panel A
88
4.5 Institutional Holdings
• Panel B: “dedicated” (long run), “transient” (short run),
and “quasi indexers” are categories
• Panel B: no difference in years held across these three
categories
• Panel B: “dedicated” investors seem to hold more OFC
incorporated firms, “transient” hold less
89
4.5 Institutional Holdings
• Panel C: “large growth”, “large value”, “small growth”,
“small value” show a few differences towards OFC firms
• From Panels A and B, relatively nimble investors
(independent investment advisors or mutual funds,
“transient” investors) seem a bit more comfortable with
OFC firms
• How we judge this depends on our feelings about mutual
funds generally (French AFA address, for example)
90
Table 9, Panels B and C
91
4.5 Institutional Voting
• How do institutions vote on proposals to reincorporate in
or away from an OFC?
• Filing Form NP-X starts 31 August 2004, after most of
our sample of reincorporation events (only 11 for 13F
holdings). Therefore, no data.
• Anecdotal evidence suggests a handful of cases
(Stanley Works, Tyco) when institutional investors
objected to moving to an OFC
92
5. Summary and conclusions
Offshore Financial Centers: Naughty or Nice?
Seems a bit of both depending on the firm
• Naughty for a growing firm from a good home
environment
• Nice for firms from certain underdeveloped places, once
other factors are controlled for
It is fun to confuse everyone and conclude “It Depends”
93