College of Business: University of Illinois at Urbana-Champaign

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When Red Tape Means a lot of Green


American executives routinely complain about the regulatory burden their businesses face. They cite red tape and the legal costs of complying with the myriad securities laws that have piled up over the last seven decades. But while American executives find our regulations burden some, many foreign companies have voluntarily listed their stocks on United States exchanges. When they do so, they put themselves under the jurisdiction of U.S. securities laws, U.S. regulators, and, potentially, U.S. courts. Why would they do this when they could so easily avoid this web of oversight by staying out of U.S. stock markets? The answer is that it saves them a lot more than it costs.

Paying the Price

Paul Vaaler, an associate professor of international business, has spent years researching the influx of foreign listings on American stock exchanges. As a lawyer, he has an appreciation for the role the regulatory environment plays in a firm’s operation. He believes investor psychology plays an important part in the growth of such listings and the willingness of foreign companies to take on the burden of regulation.

According to Vaaler, investors are willing to accept lower returns on corporate bonds if they think their money is safe. And it is more likely to be safe when invested in companies that are under tough regulatory oversight—as are companies that register their stocks on U.S. exchanges. Lower interest on bonds translates into hefty cost savings for the corporations that issue them.

Vaaler offers this example. “Let’s say you’re a one billion-dollar-a-year company, and your weighted cost of capital is 10 percent before you list here. After listing, it goes down to nine percent. You could save millions of dollars in financing costs. These savings far outweigh the legal fees and other costs associated with complying with U.S. laws.”
And by listing on U.S. exchanges, you increase the number of potential investors who will bid on your stock.

“Whenever you bring more people into an auction, the price goes up,” Vaaler says.

This means that a growing company based in a country with lax regulations isn’t stuck with the financial consequences. “Our research shows these companies can go abroad by establishing a U.S. presence legally and financially and still keep their offices and their factories back home. For example, the headquarters can remain in Sao Paolo, even as the company maintains a securities listing on the New York Stock exchange. Where you’re from doesn’t necessarily determine the corporate rules of the game your company will follow.”

So even if investor protection in many foreign countries is flimsy at best, companies from those countries can gain a seal of approval by listing their stocks on U.S. exchanges. Of course, U.S. laws and regulations don’t guarantee absolute security for investors—witness the huge investor losses from the debacles at Enron, WorldCom, and other companies caught up in recent waves of corporate accounting scandals. But this happens much less frequently here than it does in countries with less stringent investor protections. When investors do get burned here, they can seek redress in American courts and criminal action by federal and state prosecutors. Conspirators in the Enron scandal, for instance, received long jail sentences. In other countries, they might have escaped punishment.

The Need to Raise Money

The ability to raise capital and sell stock is vital to a growth company. But investors won’t buy if they fear they will lose their shirts because of an inadequate regulatory and legal system. This is a particular problem for growth companies located in emerging markets such as Brazil, Russia, India, and China. To get that capital, they need to go global, at least in terms of where their securities are registered.

“This is part of globalization,” says Vaaler. “It means that standards of corporate governance across the world have some tendency toward convergence. But it’s not a race to the bottom (in terms of standards). It’s more of a race toward the top.”

There are, of course, many other reasons why foreign firms might want to list their stocks here. Listing increases name recognition among investors. It also increases the ease with which stocks can be bought and sold and makes it easier to facilitate overseas mergers and acquisitions. Some firms choose to list on U.S. exchanges to take advantage of the bigger and deeper capital markets in this country—there’s simply more money to be invested. But Vaaler’s research finds that the primary reason firms in emerging markets “bond” with—that is, agree to adhere to—the U.S. system of regulations is because it improves their financial position. “This factor—and this factor alone—would cause firms from emerging markets to list their stocks here,” says Vaaler.

“Our hypothesis asserts that companies from certain countries have trouble attracting small shareholders. Growth companies need to raise a lot of money at reasonable costs, and they need small shareholders to do that. Right now firms in Brazil, Russia,
India, and China—together known as the BRIC nations—tend to be owned by one big, dominant shareholder, along with a few management insiders, and their family members and close associates. If these companies want to grow, they need to bring in a lot more investors.”

Vaaler‘s research helps to explain the explosion of foreign listings on U.S. exchanges since the early 1990s. The number of foreign firms listed on the New York Stock Exchange and the NASDAQ grew from 170 in 1990 to 750 in 2000. The cumulative trading volume in these firms exceeded $750 billion.

There are also benefits for the United States when foreign firms list their stocks on American exchanges, says Vaaler. One is that it helps to financially strengthen U.S. stock exchanges because the new foreign firms pay hefty fees for stock listings here. The new arrivals also help to pump up trading volume, which generates business for brokerage houses, and the influx of foreign listings helps to keep American stock exchanges at the center of the financial world.

The Common Law Advantage

Of course, tough regulations on paper are meaningless unless they are enforced, and that’s where the United States, Britain, and Canada often have a decided advantage. Their legal systems are grounded in common law, which is based on local legal customs and on precedents established by court decisions. It evolved over many centuries in Britain and was incorporated into the laws of the United States and Canada. For investors, common law provides a day in court and a legal framework for seeking to be made whole when they have suffered losses as a result of illegal behavior. When a corporate scandal hits in common law countries, it doesn’t take long for investors who have been burned to stream into court seeking justice. Investors in civil law countries, which is most of the rest of the world, don’t necessarily have the same right of redress.

“In civil law traditions, you might not be able to go to court,” says Vaaler. “You might have to go to legislators or regulators. The net effect is that in civil law traditions, there are fewer judicial remedies for the aggrieved shareholder. The common law tradition means more protection, particularly for aggrieved small shareholders.”

What’s the Bottom Line?

The U.S. regulatory environment is particularly demanding, a fact foreign companies have come to accept. Yet it is a system that American companies often resent, and one that may not be fully appreciated by American investors who don’t understand how tough U.S. standards are in comparison to most other countries—and the benefits of those tough standards. “People complain about the scandals at Tyco, and Enron, or WorldCom,” says Vaaler. “But these are exceptions. In many emerging markets, these types of self-dealing and corruption are all too frequent, and they are accepted.”

UIUC College of Business