incorporation in offshore financial centers: naughty or nice?

Incorporation in Offshore Financial Centers: Naughty or Nice?

Warren Bailey and Edith X. Liu

Cornell University

26th April 2014

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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?

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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)

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• 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

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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?

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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.”

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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


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

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• 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 revenue11

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 OFCsMorriss (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 jurisdictions13

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?

15Bank accounts in the Cayman Islands (legal under US law)

China’s elite hiding wealth?

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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。”

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.

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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 exemptions18

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)

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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).

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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?

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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

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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”

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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)

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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

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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?

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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.

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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

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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)

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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)

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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)

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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?

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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

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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)

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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

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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…

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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.

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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.

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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

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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

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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.

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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.

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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

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• 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)

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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.

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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.

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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 holdings49

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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http://www.indexmundi.com/


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)

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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

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3.3 Methodology1. 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

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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

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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

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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%

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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

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Table 1, Panel A


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

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60Table 1, Panel B

61Table 1, Panel C


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 ...

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• 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

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Table 2, Panel A


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

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Table 2, Panel B

4.2 Tobin’s q

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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), r-squared rises to over 11%

4.2 Tobin’s q

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• 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.

4.2 Tobin’s q

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• 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).

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Table 3, Panel A

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Table 3, Panel B

•Negative (?) valuation effect with cross listing

•Seems to come from China/HK firms

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

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Table 4

4.2 Tobin’s qTable 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 bad75

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Table 5

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

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

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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%

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Table 6, Panel A

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Table 6 Panel B: China/HK firms only

•Tiny sample suggests OFC incorporation is bad

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Table 4

Table 7: single-stage equation to explain IPO returns

•Significantly negative slopes on OFC dummy

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.

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85

Table 8, Panel A

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Table 8, Panel B


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

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88Table 9, Panel A


•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

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•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)

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91Table 9, Panels B and C

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

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5. Summary and conclusionsOffshore 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”

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