Lemon Signaling in Cross-Listings Michal Barzuza*

Transcription

1 Lemon Signaling in Cross-Listings Mihal Barzuza* This paper analyzes the deision to ross-list by managers and ontrolling shareholders assuming that they have private information with respet to the amount of private benefits of ontrol that they an extrat from their firms. Our model shows that sine ross-listing restrits the extration of private benefits of ontrol it serves as a signal that a manager or a ontrolling shareholder does not have many opportunities to extrat private benefits of ontrol. The analysis produes the following preditions. First, we find that while the opportunity to bond and signal low private benefits of ontrol enourages managers to ross-list, ounter intuitively, it may disourage ontrolling shareholders from rosslisting, sine suh a signal may derease the ontrol premium they an get for their shares. The model further predits that the value of the foreign firms in their home markets should derease but the value of the ontrol premium in those firms should inrease as a result of ross-listing by peers. Lastly, onsistent with the evidene, the model predits that there are no irumstanes in whih all firms ross-list, and that the firms that do not ross-list would be dominated by ontrolling shareholders. Our results have several impliations. First, they suggest that a weak bonding may result in U.S. apital markets attrating more firms than a strong bonding would, as was offered by a reent study and by an Interim Report of the Committee on Capital Markets Regulation. Seond, it predits that two markets may o-exist, one with a higher and one with a lower, inadequate level of dislosure. Thus, it may support some form of international regulation or harmonization. Third, our analysis suggests that a full onvergene around the world to effiient orporate governane paradigm is not likely to happen. Lastly and more generally, our results may suggest that the need in regulating ontrolling shareholders may be stronger than the need in regulating managers. Keywords: Cross-list, rivate benefits, Controlling shareholders, ontrol premium, Signaling *Assoiate rofessor, University of irginia Shool of Law. For their useful omments and suggestions I thank [] and workshop and onferene partiipants at arvard, irginia, and the annual meetings of the Canadian, Israeli, and European law and eonomis assoiations.

2 . Introdution The last deade has witnessed the inreasing prevalene of ross-listing by foreign firms on U.S. exhanges. Typially, when ross-listing a foreign firm undertakes higher dislosure obligations and exposes itself to better enforement mehanisms than the ones it faed previously in its foreign market. Why firms ross-list has been the subjet of extensive literature. Equally interesting, and less disussed, is the question pertaining to why so many firms hoose not to ross-list, given proven benefits from ross-listing. The dominant hypothesis that explains ross-listing in the literature, the bonding hypothesis, asserts that managers and ontrolling shareholders ross-list in order to ommit to redue their extration of private benefits of ontrol (Coffee (999, 00, Stulz (999. That is, ross-listing is a way of onvergene to U.S. orporate governane standards. Although a signifiant body of evidene supports the fat that bonding is assoiated with ross-listing, there is evidene to suggest that it annot explain the ross-listing phenomenon in full. To start with, the firms that hoose to remain in their foreign markets exhibit a negative prie reation upon a ross-listing announement by one of their peers (Melvin and Tonone (004, Lee (003, whih seems to suggest that some form of signaling is taking plae. Seond, while ross-listing results in a signifiant positive prie reation the bonding itself is relatively weak (Liht (003, Siegel (00. Third, while many firms hoose to ross-list, many others hoose not to despite the signifiant positive prie reation, and more important, the deision to ross-list is inversely related to ontrol rights (Doidge et al (006. This paper develops a new explanation for ross-listing based on asymmetri information with respet to the extration of private benefits of ontrol. It suggests that by deiding whether or not to ross-list managers and ontrolling shareholders signal private information about the private benefits they an extrat from their firms. In partiular, it shows that when a manager or a ontrolling shareholder ross-lists he signals that he an not extrat a large amount of private benefits of ontrol from his firm. Our model shows that this signaling effet influenes managers and ontrolling shareholders inentives to ross-list in very different ways. Managers may benefit from signaling extration of small private benefits sine that will inrease the value of their shares. Controlling shareholders, ounter-intuitively, may benefit from onveying the opposite signal, that is, that they an extrat large private benefits of ontrol sine that would inrease the value of the ontrol premium they an get for their blok. Our analysis assumes that firms differ in how ostly it is to extrat private benefits from them. For instane, while in firms that operate in onentrated industries there may be lots of rents to extrat, in firms that operate in ompetitive industries extration of Other explanations inlude suggesting that firms ross-list in order to dismantle market segmentation and gain aess to more liquid markets (Foerster and Karolyi (999, and to inrease visibility to U.S. investors, (Lang et al., 003. Some proponents of the bonding hypothesis see this predition as supported by bonding (see Coffee (00. Sine bonding limits both managers and ontrolling shareholders from extrating private benefits of ontrol we think that the bonding hypothesis does not fully explain why ontrolling shareholders show signifiantly weaker tendeny to ross-list than managers. For a broader disussion of this issue see part 6 below.

3 private benefits may risk the ompetitiveness of the firm. Consequently, managers and ontrolling shareholders of the latter type of firms an extrat less private benefits of ontrol than managers and ontrolling shareholders of the former type. We also assume that these differenes in extration are not ompletely observable to the publi. The manager and the ontrolling shareholder have private information regarding how muh private benefits they an extrat and the fators that onstrain them from extrating private benefits of ontrol suh as the level of ompetition a speifi firm is faing. We onsider first a manager interested in selling some of his shares to the publi. Managers of all types, those that an extrat small and those that an extrat large private benefits of ontrol, would like to signal that they an extrat only small private benefits from their firm sine that would inrease the value of their shares. 3 Yet, managers who are able to extrat large private benefits of ontrol, have more to lose from migrating from a lax regime to a strit one, whih would ut some of their opportunities, than managers who do not have lots of opportunities to extrat private benefits of ontrol to begin with. Consequently, by tightening their restritions some managers redibly onvey information that they an extrat only a small amount of private benefits of ontrol from their firms. Modeling managers deision to ross-list we get the following results. First, the prie reation to ross-listing is larger under our hypothesis than under the bonding hypothesis, and the motivation for ross-listing is aordingly stronger. In addition, onsistent with the evidene and unlike the bonding hypothesis, our model predits that the value of firms that do not ross-list should derease as a result of ross-listing by peers. When we model the deision to ross-list by ontrolling shareholders we get markedly different results. Unlike managers, ontrolling shareholders an sell the opportunity to extrat private benefits of ontrol to others. Typially, in suh a transation the buyer pays a ontrol premium that reflets the opportunities to extrat private benefits from the firm (Dyk and Zingales (004, Barlay and olderness (989. As a result, signaling that a ontrolling shareholder is able to extrat large benefits from his firm would inrease the ontrol premium he an get and eventually may inrease the prie he an get for his ontrolling blok. A deision not to ross-list while other firms do would onvey the desirable signal. Analyzing the possible equilibria for ontrolling shareholders, for ases in whih the likelihood of selling the ontrol blok is signifiant 4 leads to the following results. First, our model shows that, in these irumstanes, an equilibrium in whih everyone rosslists does not exist. That is, it predits that there will always be ontrolling shareholders that hoose to remain in their home foreign markets. 5 These results are onsistent with the evidene that many firms do not ross-list and that the deision to ross-list is inversely related to ontrol rights (see Doidge et al (006. These results suggest that the 3 Suh a signal would inrease the value of the firms shares and in our model the manager holds some of his firm s shares. In reality, managers wealth is frequently tied to firm value to a ertain extent either beause they hold their firms shares, like in the model, or through bonuses or other rewards that are influened by performane. 4 The model assumes that the likelihood of selling the ontrol blok is suffiiently to make the prie that the ontrolling shareholder faes for his blok dereasing in. The preise ondition is ondition (8. 5 While under the bonding hypothesis it is possible that some firms do not ross-list it is also possible that everyone ross-lists.

4 U.S. apital markets annot hope to attrat all firms from foreign markets and that full onvergene to U.S. orporate governane standards is not likely to happen. Seond, in a separating equilibrium in whih some of the ontrolling shareholders ross-list our analysis shows that the value of the ontrol blok of the firms that remain in foreign markets may inrease as a result of ross-listing by peers, whih explains their deision to forgo the benefits of ross-listing. Why then would ontrolling shareholders ross-list at all? Controlling shareholders would ross-list only if by ross-listing they get benefits other than bonding, suh as greater liquidity and visibility to US investors. Thus, our model suggests that, when the likelihood of selling the ontrol blok is high, the bonding itself serves as a motivation not to ross-list for ontrolling shareholders. This is true even for ontrolling shareholders that extrat only small amount of private benefits of ontrol. In different than the bonding hypothesis we predit that if they do hoose to ross-list, it is despite of the bonding assoiated with ross-listing rather than beause of it. Reent studies have shown that the U.S. apital market is losing its ompetitive edge in attrating ross-listings (Zingales (006. Relying on this study an interim report released by the Committee on Capital Markets Regulation alled to ease regulation and enforement in the U.S. apital markets. 6 Yet, a debate is revolving over whether a derease in regulation and enforement is the right solution. 7 This artile suggests that indeed a strong bonding may deter some firms from ross-listing. Sine some of the firms ross-list despite of the bonding and beause of other benefits, they will ross-list only if the bonding is not partiularly strong. The above does not suggest that a weak bonding is desirable from a normative point of view but only that it ould help the U.S. to attrat more firms. In fat, our analysis shows that ontrolling shareholders may opt for suboptimal minority protetion. Thus, our analysis predits the emergene of two markets for dislosure, one with high level of dislosure and one with inadequate level of dislosure. These results an explain the emergene of the London Stok Exhange that offers lower dislosure standards as a main ompetitor to the U.S. apital markets and may support some form of international regulation or harmonization. In revealing a motivation not to ross-list our analysis has impliations for the debate over whether orporations around the world onverge to an effiient orporate governane paradigm. The analysis suggests that suh onvergene, either atual or funtional, is not likely to happen for all firms. Lastly, these effets should be taken into aount in disussions over the desirability of regulation in orporate law. Our analysis draws a sharp distintion between managers and ontrolling shareholders in suggesting that in the midstream stage of the firm s life managers have inentives to improve orporate governane while ontrolling shareholders have inentives to degrade orporate governane. Thus, it suggests that there may be more reasons to regulate the relationship between ontrolling shareholders and minority shareholders than the relationship between managers and dispersed shareholders. 6 See Interim Report of the Committee on Capital Markets Regulation (November 30, See igh and Low Finane: S.E.C. to Firms: Keep Money, Forget Rules Wall Street Journal, (De

5 Several studies have offered signaling based explanations for ross-listing. Fuerst (998 presents a model in whih firms move to striter regulatory regime to redibly onvey information on their firm s future prospets. Blass and Yafeh (00 similarly suggest that firms use osts assoiated with ross-listing to redibly onvey information about their value. Coffee (00 and Melvin and Tonone (004 suggest that by rosslisting firms signal high growth opportunities. Our analysis is different than theirs in that the signaling effet is reated beause of asymmetri information with respet to the extration of private benefits of ontrol rather than asymmetri information with respet to firm value or projets value or osts of ross-listing. Our results are markedly different as we predit opposite behavior by managers and ontrolling shareholders. Our analysis is also related to the literature on the way asymmetri information affets the adoption of orporate governane arrangements when firms first go publi. Bebhuk (00 has shown that in the presene of asymmetri information regarding firm value, owners might adopt rules with sub-optimal protetion to shareholders to signal the high value of their firm. Iaobui (00 showed that in the presene of suh asymmetries, firms might adopt exessive levels of investor protetion, also to signal high value. The urrent paper ontributes to this literature by showing how asymmetri information about private benefits, rather than firm value, affets the hoie of rules. Unlike previous literature, we show that whether asymmetri information leads firms to improve the effiieny of the legal rules that govern them or to worsen them depends on whether or not the firms has a ontrolling shareholder. The analysis proeeds as follows. art lays out the setting for the managers ase. art 3 analyzes managers deision to ross-list when information is symmetri. art 4 introdues asymmetri information to managers deision whether to ross-list. art 5 lays out the setting for the ontrolling shareholders ase. art 6 analyzes ontrolling shareholders deision whether to ross-list when information is symmetri. art 6 introdues asymmetri information to ontrolling shareholders deision whether to ross-list. art 7 disusses the empirial impliations of the analysis and offers a way to test it. art 8 derives impliations for the literature on ross-listing, the ompetitiveness of Amerian apital markets, the likelihood of onvergene, and the regulation of orporate law.. Framework of Analysis for Managers In this part we assume that there is no ontrolling shareholder, but only dispersed shareholders, that is, there is no shareholder who holds suffiiently large portion of the voting rights for whom it is profitable and feasible to effetively ontrol the firm. As a result, we assume that the manager makes the deision whether or not to ross-list. 8.. The Environment 8 Under U.S. state orporate law the board of diretors has the power to list or delist on and from exhanges (See Kahan (997. There is no reason to believe that the law is different in most of the ountries from whih firms ross-list on U.S. exhanges. Thus, when there is no ontrolling shareholder we assume that the manager is ontrolling the deision whether or not to ross-list. In parts 5-6 we assume that there is a ontrolling shareholder with suffiient ontrol to make the deision himself. 4

6 We onsider a four period setting. At T=0 the manager holds a fration of the firm ash flow, that is the model starts at the midstream stage of the firm life. There are two types of firms. From the first type of firms it is more ostly to extrat private benefits than from the seond type, and as a result managers of the first type would extrat less than managers of the seond type. The manager reeives a private signal regarding how ostly it is for him to extrat private benefits. The manager knows, based on the signal, how muh private benefits he an extrat without having the osts of extration for him outweigh its benefits. The uninformed investors do not know whether the manager an extrat high or low private benefits of ontrol but they hold a prior probability p that the manager an extrat only low private benefits of ontrol. At T= the manager sells a fration of his shares to the publi. rior to the sell he deides whether to ross-list or not. From his deision whether to ross-list or not investors draw inferenes on the amount of private benefits he an extrat. At T= the manager extrats private benefits of ontrol. At T=3 payoffs are realized to the manager and the investors. Our model builds on Bebhuk (00 whih shows that asymmetri information with respet to firm value may result in the hoie of suboptimal shareholder protetion at the IO stage. Like Bebhuk we assume that the extration of private benefits is ostly and that the manager and the ontrolling shareholder extrat the amount of private benefits that maximize their payoffs given the regime that governs their firm and the osts assoiated with the extration. Unlike Bebhuk we assume that some of the osts that are assoiated with the extration of private benefits of ontrol, and the extration itself, rather than firm value, are not observable to the publi. As a result, as the model shows managers and ontrolling shareholders may want to signal information about the private benefits of ontrol they extrat. This feature of the model is the essene of this paper T=0 The Manager olds a Fration of the Firm s Cash Flow. In the first period a foreign firm s shares are listed on its home market stok exhange. A manager of the foreign firm, who has an effetive ontrol of it, holds a fration of the firm s ash flow. The rest of the shares, namely a fration of - of the firm ash flow, are held by the publi. - <, that is, the model takes plae in the midstream stage of the firm s life. In this period the manager reeives a private signal with respet to what would be the osts of extrating private benefits from his firm, from whih he derives what is the amount of private benefits of ontrol that he an extrat from his firm. 0 The Investors do not have information on how muh private benefits the manager an extrat but they hold a prior probability p that the manager an extrat only low private benefits of ontrol.... T= The Manager Chooses a Legal Regime and Then Sells an Additional Fration of the Firm to the ubli 9 As this artile shows fousing on the extration of private benefits, rather than firms value, as an unobservable fator leads to qualitatively different results. An additional differene between our model and Bebhuk s model is that while he fouses on the IO stage we fous on the midstream stage. 0 For instane, a manager that reeives a signal that his firm is a type- firm know that the osts of extration for him are high and therefore he has less opportunities to extrat private benefits of ontrol than a manager of a type-l firm. 5

7 In the seond period the manager sells an additional fration of the firm to the publi. Like Bebhuk (00 we assume that prior to selling the manager has an opportunity to deide on the level of investor protetion that will govern his firm [, ]. We define to inlude the level of dislosure obligations and the level of enforement, and any other fators suh as analysts overage, that provide investors with protetion from extration of private benefits by managers. When selling additional shares to the publi the manager offers the ontrat (, in whih represents the prie he asks for the shares and represents the legal protetions desribed above. We assume ompetition in the market for investors so that the owner an get the prie he asks as long as this prie is not higher than the value of his shares to investors...3. T= The Manager Extrats rivate Benefits In the third period, after selling a fration to the publi, the manager extrats the amount of private benefits b that maximize the ex post value of his payments. The extration of private benefits is ineffiient, that is, it is assoiated with osts, so that if the osts to the firms of the extration are b the manager gets out of it only [ b L( b, C( b, ]. The osts that the extration of private benefits of ontrol imposes are of two types: ineffiieny osts assoiate with the extration that are independent of the legal regime, and osts that are assoiated with the legal regime that inhibits the extration. In assuming two kinds of osts we divert from existing models on extration of private benefits of ontrol whih assume that all of the osts from extration of private benefits are assoiated with the legal regime (see Bebhuk ( Ineffiieny Costs that are Independent of the Legal Regime Some of the ineffiieny osts that the extration of private benefits imposes are independent of the legal regime. For example, the extration of private benefits in a firm that operates in a ompetitive market inreases the likelihood that suh a firm will go bankrupt. Or, the opportunity to extrat private benefits may lead the manager to hoose a worse investment over a better one if the former allows him to extrat larger benefits than the latter. Or, if the manager extrats private benefits he may also have to distribute private benefits to others in the firm. As a result, even if the law does not limit the extration of private benefits of ontrol, we assume that suh extration imposes ineffiieny osts on the firm. These osts are denoted by C ( b,. We assume that these osts inrease with the extration of private benefits of ontrol. For the sake of simpliity we assume that C ( b, = b. C C C C This an be generalized as C ( 0, = 0, (0,, = 0, > 0 and that > 0. b b b We do not assume that the marginal osts of extration inrease with the level of private benefits of ontrol. To be sure, some of these marginal osts might inrease with the private benefits of ontrol. For instane, the higher the private benefits the manager takes the worse are the investments that he might undertake. 6

8 There are strong reasons to believe that firms differ in how diffiult it is to extrat private benefits of ontrol from them. Whereas in some ompanies it is easy to extrat large private benefits of ontrol in others it is almost impossible to do so without hurting the firm signifiantly (Roe (00. Following our risk of bankrupty example, while an extration of private benefits from firms in ompetitive industries ould impair the firm s likelihood to survive the ompetition, an extration of private benefits from firms with market power is likely to be less harmful and therefore is more likely to happen. Indeed, reent studies have shown negative orrelation between the extration of private benefit of ontrol and produt market ompetition (Guadalupe and erez-gonzalez (006. Similarly, while in some firms the manager an extrat private benefits primarily to himself without giving perks to others in others he may have to distribute some perks to others as well. Or in some firms the internal ontrol mehanisms are better than in others and therefore the manager does not extrat high private benefits of ontrol or otherwise would be fired. As a result the extration of private benefits is expeted to vary aross firms. The extration of private benefits is, for the most part, not observable, the very nature of suh extration is that it remains seret. Exposing the exat amount of private benefits of ontrol that the manager extrats and the ways in whih he extrats them may lead shareholders to blok the extration. Indeed empirial studies that assess private benefits of ontrol use indiret assessment by others, suh as ontrol premium that is paid for the sale of ontrol bloks (Dyk and Zingales (004, Barley and olderness (989, and the differenes in prie of shares with high and low voting rights (Nenova (003. The fators that lead to more or less extration are also, in part not observable. While investors generally know how ompetitive industries are, there is little information on what is exatly the level of ompetition a speifi firm is faing or to what extent the board is fulfilling its monitoring role. Thus we assume that the manager has private information on how muh he an extrat from his firm, and what are the osts of extration for him. In partiular, we assume C and b to be unobservable to the publi. To apture the unobservable differenes among firms the model inludes two types of ompanies. For the first type, whih is denoted by L, the extration of private benefits is relatively easy and therefore assoiated with relatively low osts (C L. For the seond type, whih is denoted by, the extration of private benefits is more diffiult and aordingly results in higher osts (C. The proportion of type L firms is p (0, and the proportion of type firms is thus -p. The type of the firm C is not observable to the market. In a separating equilibrium the market draws inferenes on a firm s type. In a Yet, in other ases the marginal osts might not inrease and even derease with the amount of private benefits of ontrol. For instane, the mere fat that the manager takes perks to himself might require him to distribute some perks to others. Yet, if he inreases his onsumption of private benefits he might not have to inrease it to others or in the worse ase will inrease it only in a linear way. Our qualitative results though do not hange signifiantly if we assume inreasing marginal osts. We also assume that ex post, the legal regime an trak, with some likelihood, partiular oasions of extration of private benefits of ontrol. Thus, if a manager extrats private benefits in an illegal way he may get aught. That is, with the investment of some osts a speifi extration is observable to the regulator ex post. 7

9 pooling equilibrium, where the market doesn t know the firm s type investors assume that a firm s osts are: C = pc ( p C L..3.. Costs Assoiated with the Legal Limitation on Extrating rivate Benefits of Control Seond, there are osts that are assoiated with and depend on the regulatory regime that the manager has adopted in the seond period, before selling his shares to the publi. Strit regulatory environment that requires high level of dislosure and involves high enforement inreases the risk that the ontrolling shareholder will be sued for extrating private benefits. Following Bebhuk (00 and to simplify the mathematial derivations, we assume that L( b, = b The Amount of rivate Benefits that the Manager Extrats Given the osts assoiated with the extration of private benefits of ontrol the manager extrats the amount of private benefits that maximizes the ex post value of his blok. As the first order ondition shows the private benefits that the manager extrats are dereasing in C. The intuition here is straight-forward. The higher the osts to the firm of extrating private benefits of ontrol, the less the manager (who holds some fration of the firm s ash flow will extrat suh benefits. 4 The manager s maximization problem is given by: Max b b b ( b b (. Solving for the F.O.C the level private benefits that the manager will extrat is b =. Sine the interest of this paper is in how private benefits affet the deision to rosslist we shall fous on the ases in whih the manager hooses to extrat some private benefits and therefore assume that ( > T=3 ayoffs are realized At T=3 ayoffs are realized for the manager and the investors. L L L L 3 This an be generalized as L ( 0, = 0, (0,, > 0, > 0 and > 0. As assumed b b b in Bebhuk (00 and Burkhart, anunzi, and Gromb (997, Not surprisingly, the private benefits that the manager extrats are also dereasing in. The higher the risk that the manager exposes himself to when he extrats private benefits of ontrol the less he tends to extrat private benefits. 8

10 ..4..ayoffs for the Manager Given that the manager extrats private benefits of ontrol in the size of ( b = the manager s ex post payoffs would be ( (3 π =..4..ayoffs for the Investors - The rie that Investors Would be Willing to ay for the shares The investors ex post payoffs, are equal to the value of the shares ex ante minus the harm aused by the private benefits that the manager is antiipated to extrat: (4 π s = I =. Sine investors antiipate the extration of private benefits of ontrol this is also the prie I, that they would be willing to pay for the fration of shares. That is they would disount the prie they are willing to pay for the shares to reflet the inreased private benefits that the manager will extrat. Note that the payoffs to the investors, and as a result the prie that they will pay for π s the fration of shares, are inreasing in : = > 0. Consequently, the investors would be willing to pay more for shares of firms that ross-list. The payoffs to investors are also inreasing in the firm s type. Reall that the firm type desribes the osts assoiated with the extration of private benefits. In a Type- firm, for instane, the osts assoiated with the extration of private benefits are high and as a result the manager is likely to extrat less private benefits of ontrol. Investors are willing to pay more for this firm (whose manager takes less to his poket, than for a Type-L firm in whih the manager is expeted to extrat higher private benefits of ontrol. 3. Managers - Symmetri Information The Bonding ypothesis In order to demonstrate the signaling effets we shall fous first on the symmetri information ase as a benhmark. We analyze what would happen if the publi knew for eah firm the osts of extrating private benefits, and therefore the amount of private benefits its manager extrats. The symmetri information model demonstrates that, as was offered by Coffee (999, 00, some managers hoose to ross-list in order to bond themselves to a striter legal regime and ommit to extrat small private benefits of ontrol. It also shows, as offered by Coffee (999, 00 that some managers may hoose not to ross-list. 9

11 In hoosing the legal regime the manager, knowing that investors antiipate his ex post behavior, should pik the regime that maximizes his ex ante payoffs, whih payoffs onsist of the private benefits he extrats, and the value of his shares: ( (5 π = b b b ( ( b I =. The FOC that determines the legal regime that the manager will hoose is: π (6 = As the FOC shows the profitability of ross-listing to the manager depends on the level of the ineffiieny osts that result from his extration of private benefits. We an derive the minimum osts that are neessary for a manager to fae in order to ross-list: ROOSITION : Under symmetri information, managers that ross-list are those whose is large enough to satisfy the following ondition: (7 > The intuition for this result whih is proved in the appendix is the following. The higher osts of extration for a manager from his firm, the less private benefits the manager expets to extrat, and in turn the less he loses from migrating to a striter regime that limits his extration. For suffiiently high osts the inrease in the market prie of his shares would outweigh the loss of private benefits to the manager and motivate him to ross-list. Thus, we show that when there are differene is osts of extration, onsistent with the preditions of the bonding hypothesis (see Coffee (999, 00 managers that would ross-list are those that have higher osts and therefore fewer opportunities to extrat private benefits of ontrol. In the following parts we demonstrate that introduing asymmetri information to the model strengthens the motivation to ross-list for managers. Our analysis of asymmetri information builds on the bonding hypothesis in assuming that by ross-listing managers and ontrolling shareholders ommit to extrat less private benefits of ontrol. We are analyzing how the introdution of asymmetri information affets firms motivation to bond. 4. Managers - Asymmetri Information the Signaling of rivate Benefits ypothesis Under asymmetri information investors do not observe the type of the firm, that is, they do not observe how ostly it is to extrat private benefits from eah firm and how muh eah manager extrats as a result. 5 This part analyzes two possible equilibria that 5 The onept of equilibrium that we adopt is a erfet Bayesian Equilibrium with a refinement of the Cho-Kreps intuitive riterion. A set of strategies and a belief funtion onstitute a BE iff: 0

12 may result. 6 A separating equilibrium in whih some managers ross-list and some do not ross-list or a pooling equilibrium in whih all managers ross-list. 7 Analyzing the properties of a separating equilibrium we find that the prie reation to ross-listing under asymmetri information (the signaling of private benefits hypothesis is stronger than the prie reation to ross-listing under symmetri information ( the bonding hypothesis. Seond, and related, we show that the threshold for ross-listing is lower under asymmetri information. That is, firms that would not ross-list under symmetri information might do so under asymmetri information. Lastly, we show that for firms that remain in their home markets the value of the shares should derease as a result of ross-listing by peers. 4.. There is no ooling Equilibrium in whih everyone Remains in Foreign Markets ROOSITION : There is no pooling equilibrium in whih everyone stays in foreign markets Our first step is to show that there is no pooling equilibrium in whih all of the managers hoose to remain in foreign markets. The proof of this result is available in the appendix. In fat as the proof shows the only possible pooling equilibrium is one in whih all managers ross-list on the stringent regime, the one with the highest. 4.. A Separating Equilibrium Managers Signal Low rivate Benefits of Control One possible equilibrium is a separating equilibrium in whih some managers rosslist and others do not. A separating equilibrium will result if and only if managers of Type-L ompanies hoose not to mimi the managers of Type- ompanies. This leads to the following ondition. ROOSITION 3: if managers of Type-L ompanies prefer their ineffiient symmetri ontrat ( (, on the ontrat ( (,, 8 then the unique solution is a separating L (a The manager s strategy is optimal for him given the investors strategy. (b Given their beliefs about whih type of manager they fae the investors hoie whether to aept or rejet a ontrat is optimal for them. ( The belief funtion is derived from the managers strategy using Bayes law when possible. (d Investors beliefs satisfy the Cho-Kreps intuitive riterion. An equilibrium satisfies the intuitive riterion if the bad type of manager would not adopt an out of equilibrium ontrat if he does worse with this ontrat, relative to its expeted equilibrium utility even if that would lead him to be onsidered as a good type and the good type manager would adopt suh a ontrat if he would do better with this ontrat, relative to its expeted equilibrium utility if adopting this ontrat would lead him to be reognized as the good type. The Cho-Kreps riterion is aepted as a refinement of BE sine when only one type an possibly benefit from deviation, then onstrution of beliefs that the other side has deviated upon witnessing a deviation is not reasonable. 6 There is an additional possible equilibrium that we do not disuss here, a hybrid equilibrium. 7 There is another possible equilibrium a hybrid equilibrium whih we do not analyze here. 8 This ondition ensures that the manager of a Type-L firm has no inentive to mimi the manager of a Type- firm. For a separating equilibrium to hold the ondition doesn t have to inlude also a requirement that the manager of a Type- firm is better off not pooling with the manages of Type-L firms sine as shown in proposition the only pooling equilibrium that an exist is an equilibrium on the stritest legal

13 equilibrium in whih managers of Type-L firms are offering their ineffiient symmetri information ontrat ( L (, and the managers of Type- firms are offering a ~ ~ ~ [( L ( ] ontrat (, ( suh that = ( ( The proof for this result is available in the appendix. The following is an analysis of the properties of a separating equilibrium rie Reation to Cross-Listing is Stronger Under the Asymmetri Information Case Under the bonding hypothesis prie reation to ross-listing should reflet the effiieny gains assoiated with it. Introduing asymmetri information we get the following result: Corollary : In a separating equilibrium prie reation to ross-listing is greater than the effiieny gains from ross-listing and the expeted prie reation under the bonding hypothesis. 9 This result, whih is proved in the Appendix, is onsistent with the evidene as explained in part 7 below. The intuition for this result is as follows. Under the bonding hypothesis the market prie reation to ross-listing reflets the derease in the private benefits a manager an extrat as a result of ross-listing and the ineffiieny osts they impose. Under the signaling of private benefits hypothesis the prie reation reflets these effets plus an additional effet. A manager s deision to ross-list reveals that he in general extrats less private benefits of ontrol. The prie reation therefore also reflets the information that he will extrat a small amount of private benefits under the new regime The Threshold for Cross-listing is Lower under the Asymmetri Information Case The bonding hypothesis predits that managers will ross-list only if their share in the savings to the firm from ross-listing outweighs the redution in their private benefits of ontrol. Under the signaling of private benefits hypothesis, however, managers might hoose to ross-list even in ases where their private benefits are higher than their share in the savings to the firm from ross-listing. In partiular, as the next orollary suggests: Corollary : Firms that would not ross-list under symmetri information might rosslist under asymmetri information in order to signal their type. L L regime. Thus, if the managers of type-l ompanies hoose not to ross-list there will be a separating equilibrium. 9 Notie that we did not assume that ross-listing is assoiated with osts. If it is then orollary should only say that the prie reation to ross-listing is higher in the asymmetri information ase than in the bonding ase.

14 The intuition for this result, whih is proved in the Appendix, is as follows. By rosslisting managers get additional gains from revealing their type, that is, revealing that they in general extrat relatively low private benefits of ontrol, sine it inreases the value of their shares. These gains help to offset the loss of some private benefits to the manager. C, is lower Thus, the threshold ost for ross-listing under asymmetri information ( CL A than the threshold ost for ross-listing under symmetri information ( C. CL S CCL A C CL S C 4.5. Share alue of Firms that Do Not Cross-List Should Fall Another result of proposition relates to firms that do not ross-list. As the market learns information on the managers that ross-list it also learns information on the managers that do not to ross-list. In partiular, the market learns that managers that remain in their home markets extrat more private benefits than their peers in similar firms that have ross-listed. Corollary 3: Share value of firms that do not ross-list should fall. This result, whih is proved in the appendix is onsistent with and explain the evidene as explained in part 7 below There is a ossible ooling Equilibrium in Whih All Managers Cross-List A separating equilibrium is not the only possible equilibrium. It is also possible that all managers would ross-list, that is, a pooling equilibrium on the effiient regime. This would happen if the advantages of being onsidered as a good type outweigh, for the bad type manager, the osts of ross-listing on the stritest legal regime. In this ase the only possible equilibrium is a pooling equilibrium on the stritest legal regime. ROOSITION 4: If managers of Type-L firms prefer the ontrat ( (, on their symmetri information ontrat ( L (, then the unique solution onsists of both types hoosing to ross-list and offer the ontrat ( (,. The proof for this result is available in the appendix roperties of Separating and ooling Equilibria for Managers 3

15 The table below summarizes the properties of the possible separating and pooling equilibria for managers. ross- Who lists Who does not ross-list Results Separating equilibrium Managers with lower private benefits Managers with higher private benefits - igher prie reation to rosslisting than under bonding hypothesis - Threshold for ross-listing is lower than under bonding hypothesis - Negative prie reation to not ross-listing ooling equilibrium in whih everyone ross-lists All of the managers No one Everyone rosslists on the stringent regime No other pooling equilibrium At least some managers rosslist No managers, or some managers but not everyone No equilibrium in whih everyone does not ross-list 5. Framework of Analysis - Controlling Shareholders In this part we assume that the firm has a ontrolling shareholder that holds suffiiently large portion of shares that allows him to have ontrol over his firm and therefore he makes the deision as to whether or not to ross-list. Unlike managers, ontrolling shareholders an sell the opportunity to extrat private benefits of ontrol by selling their ontrol blok. 0 This part introdues this possibility. 5.. The Environment The setting is very similar to the manager s setting we disussed in setion exept for one thing: After he hooses the legal regime and sells a fration of his shares a 0 To be sure, managers sometimes get golden parahutes for losing their ontrol, whih may be viewed as ontrol premium. Yet, it is not lear that these golden parahutes reflet the private benefits that managers extrat from their firms sine managers many times have influene on setting their own golden parahutes. Moreover, even if they did there are less reasons to suggest that managers need to signal this kind information to their own board. 4

16 liquidity shok that might our with probability q leads the ontrolling shareholder to sell his ontrol blok. In transferring the blok the ontrolling shareholder also transfers the power to extrat private benefits from the firm. B represents the prie a ontrolling shareholder will reeive for his ontrolling blok and I represents the prie that he will get for the publily traded shares he sells to investors. For the sake of simpliity and without loss of generality it is assumed that the ontrolling shareholder has all of the bargaining power when selling his blok. Given the possibility of suh a liquidity shok the ontrolling shareholder s ex ante payoff is: ( (6 π = I qb ( q I B = ( b = b b b ( ( b In hoosing a legal regime the ontrolling shareholder takes into aount both the prie that he will get for the shares he sells to the publi and the prie that he will get for his blok. While I, the prie that investors will pay for the publi shares, is inreasing in, B, the prie that a potential buyer will pay for the ontrol blok, is dereasing in. = I q B = ( q To demonstrate the differene between the ase of a ontrolling shareholder and the ase of a manager we will fous on the ases in whih the likelihood of selling his blok, q, is suffiiently high for the ontrolling shareholder so that the effets of selling the ontrol blok with high premium outweigh the effets of selling the fration to the publi in high prie, in the sense that the overall prie that he is seeing is dereasing in : Sine = ( q (. If (8 < q for every, then the prie for both types of ontrolling shareholders is dereasing in. Thus for the rest of the analysis we assume that ondition 8 is met. 5

17 6. Controlling Shareholders Symmetri Information The symmetri information ase for the ontrolling shareholder is idential to the symmetri information ase for the manager. Thus, as this part shows the ondition for ross-listing under the symmetri information ase is the same as ondition (, the ondition for ross-listing for managers: ROOSITION 5: Under symmetri information, ontrolling shareholders will ross-list if their is suffiiently large to satisfy: (7 > This result suggests that there is no differene under the bonding hypothesis between managers and ontrolling shareholders. This result stands in ontrast to the literature that uses the bonding hypothesis to explain the observation that ontrolling shareholders have less motivation to ross-list than managers. John Coffee, who was the first to raise the bonding hypothesis, suggested that ontrolling shareholders may have less motivation to ross-list than managers sine ontrolling shareholders want to extrat private benefits of ontrol, while firms with no ontrolling shareholders tend to maximize shareholder value (Coffee (00. Yet, managers also want to extrat private benefits of ontrol and sine the board typially has the power to make listing deisions (see Kahan (997 the ageny problem here is as apparent as in the ontrolling shareholder ase. Coffee also argues that ontrolling shareholders will have less motivation to ross list sine they get ontrol premium for their blok. As long as we assume symmetri information however, as the bonding hypothesis does, there is little differene between shareholders and managers also in that respet. The osts for a manager and a ontrolling shareholder of limiting the future extration of private benefits of ontrol is the present value of the private benefits of ontrol he is expeted to extrat, whih is exatly the ontrol premium a potential buyer would be willing to pay. Thus, under the bonding hypothesis there is almost no differene between a ase in whih there is a sale of ontrol blok and a ase in whih there isn t, and aordingly no differene between managers and ontrolling shareholders. The different arises only if the ontrol premium a potential buyer would pay to the ontrolling shareholder depends on the information he has with respet to the private benefits he an extrat as a ontrolling shareholder in the firm. In that ase the ontrolling shareholder may hoose not to ross-list in order to signal that he extrats high private benefits of ontrol. As the following part demonstrates the asymmetri information assumption explains why ontrolling shareholders ross-list less than managers. This is true sine the symmetri information ase for the ontrolling shareholder is idential to the ase in whih the ontrolling shareholder keeps the blok and extrats the private benefits with ertainty. To be sure, there may be a differene if the manager position is expeted to be terminated in the near future. In that ase the horizon that he sees for extrating private benefits of ontrol is limited, yet, as long as this is not likely to happen in the near future disounting for time will make the differene between a manager and a ontrolling shareholder almost negligible. 6

18 7. Controlling Shareholders Asymmetri Information Signaling a Lemon This part analyzes the ontrolling shareholder hoie whether to ross-list under asymmetri information. 3 In onverse to the ase of a manager (namely, a firm with no ontrolling shareholder and ounter-intuitively, a ontrolling shareholder may want to signal that he extrats high private benefits of ontrol. When the market realizes that a ontrolling shareholder is of a bad type, that is, one that extrats high private benefits of ontrol, potential buyers may be willing to pay a higher ontrol premium for his ontrol blok. As a result, when the likelihood of selling the blok is suffiiently high we get the following results: First, there are no equilibria in whih everyone ross-lists. There will always be ontrolling shareholders who would stay in their home market rather than ross-list. This result is onsistent with and explains the evidene as disussed in part 8 below. Seond, a separating equilibrium in whih the ontrolling shareholders that extrat less private benefits ross-list and those that extrat more private benefits remain in their home markets may emerge. In suh equilibrium the value of the ontrol premium, as well as the value of the ontrol blok, are inreasing upon ross-listing by peers. As a result, suh equilibrium may emerge only if there are some advantages to ross-listing other than bonding. ut differently, ontrolling shareholders will not ross-list just in order to bond. Lastly, a pooling equilibrium in whih none of the ontrolling shareholders rosslists may emerge. That is, from some ountries we may view no ross-listings by ontrolling shareholders but only by managers. 6.. There is no Equilibrium in whih everyone Cross-Lists ROOSITION 6: Under ondition 8 the only pooling equilibrium is one in whih all firms do not ross-list. The intuition for this result whih is proved in the appendix is shown graphially: ( ( The pooling line is = q. Note that from (7 the pooling line is dereasing in. The ontrolling shareholders iso-rofit urves are: ( = π ( q ( Note that = q that is, hat the Type-L urve is steeper than the urve of type-. 3 We assume that when there is a ontrolling shareholder he ontrols the manager so that he makes the deision whether or not to ross-list. 7

19 For every point on the pooling line other than = there is another point with a lower whih is better for Type-L than remaining on the pooling line and worse for Type- than remaining on the pooling line. As a result, any equilibrium on the pooling line other than = is not stable. L ( ( C C L p ( 8

20 6.. Controlling Shareholders will Cross-List only if there are Advantages Other than Cross-Listing ROOSITION 7: For q that is suffiiently large to meet ondition (8 a separating equilibrium will exist only if ross-listing is assoiated with advantages other than bonding. The intuition for this result whih proof is omitted is the following: Sine the prie is dereasing in then both ontrolling shareholders prefer to be in the foreign market. The signaling effet only adds to that sine both ontrolling shareholders would benefit from signaling high private benefits of ontrol. Following are the properties of suh a separating equilibrium Control blok alue of Firms that Remain in Their ome Market Should Rise Corollary 4: The ontrol blok value of firms that remain in their home market should rise The intuition for this result whih is proved in the appendix is the following: When firms ross-list potential buyers of the ontrol blok realize that the ontrolling shareholders of those firms extrat a relatively small amount of private benefits of ontrol. As a result the potential buyers would be willing to pay only a low ontrol premium that reflets this information. otential buyers also realize that firms that remain in home markets and forgo the benefits of ross-listing do so beause they extrat a high amount of private benefits of ontrol. As a result, potential buyers would be willing to pay more for ontrol bloks of firms that remain in their home markets as their peers ross-list The threshold for Cross-Listing is igher under the Symmetri Information Case Corollary 5: Firms that would ross-list under symmetri information might not do so under asymmetri information. The intuition for this result, whih is proved in the Appendix, is as follows. By rosslisting ontrolling shareholders might suffer from revealing their type, that is, revealing that they in general extrat relatively small private benefits of ontrol. While suh information inreases the prie investors should be willing to pay it dereases the ontrol premium potential buyers would pay for the blok. If the likelihood of selling the ontrol blok is suffiiently high a ontrolling shareholder would prefer to signal that he extrats a large amount of private benefits of ontrol by staying in his home market. 4 Note that it is not only that the value of the premium is inreasing but also the value of the blok is inreasing. The reason is that every ontrolling shareholder will extrat private benefits only to the point that maximize the value of his blok, that is no ontrolling shareholder will extrat private benefits if the harm that is aused to his shares by the extration is larger than the private benefits he gets. 9

21 Thus in this ase the threshold for remaining in home markets is higher than in the symmetri information ase. C CL S C CL A C 6.3. ossible Equilibria for Controlling Shareholder This table desribes the properties of the separating and pooling equilibria for ontrolling shareholders when the likelihood that they sell their blok is suffiiently high to meet ondition 8. If ondition 8 is not met the table for ontrolling shareholders is similar to the table for managers. Separating ooling No other pooling equilibrium equilibrium in equilibrium is whih no one robust Who doesn t ross-list Results Controlling shareholders with lower private benefits, if and only if there are other benefits from ross-listing Controlling Shareholders with higher private benefits - ositive prie reation to the ontrol blok of firms that do not ross-list - Threshold for ross-listing is higher than under the bonding hypothesis ross-list No one All of the ontrolling shareholders All of the ontrolling shareholders do not ross-list No one, or some firms but not everyone At least some firms do not ross-list ross- Who lists No equilibrium in whih everyone rosslists 0

22 6.5. What if the Controlling Shareholder Can Communiate Some of this Information to otential Buyers So far we have assumed that the ontrolling shareholder does not ommuniate information about the value of his blok to potential buyers. Suh ommuniation, however, is possible to a ertain extent. A ontrolling shareholder an ommuniate to a potential buyer some information about the level of private benefits of ontrol that he extrats from his firm. Yet, for several reasons a ontrolling shareholder is not likely to ommuniate all of this information. To start with, there may not exist redible ways to onvey suh information. The very nature of the extration of private benefits is that it is not observable. Seond, even if there are redible ways to ommuniate suh information a ontrolling shareholder may not want to reveal the exat ways in whih he extrats private benefits of ontrol. The extration may be not legal and revealing information on it may inrease the risk for shareholders suits against him, or even just shed ugly light on him. Lastly and most importantly, for suh a ommuniation to be effetive the ontrolling shareholder needs to give the information before the deal is onsummated. As a result he faes the risk that the information is out, while the deal hasn t onsummated and the other shareholders have information and ability to limit his extration. Still, to reflet the ability of the ontrolling shareholder to onvey some of this information to the potential buyer we an inlude a disount fator whih reflets the possibility that the potential buyer has some information about the firm type. If potential buyers have some information the differene between having to sell a blok and not having to sell it is smaller. As a result, in order for the information asymmetry to have the effets we desribed, q needs to be larger than what we ve assumed so far. For a q that is suffiiently large our results are likely to hold. At some level though, if the information that is not being ommuniated is negligible enough it may be that the ontrolling shareholder will are more about signaling to the publi investors than to a potential buyer of the ontrol blok. In that ase the ontrolling shareholder will have similar inentives to those of managers. We believe though, as explained above, that signifiant information is not being ommuniated and therefore signaling to a potential buyer is important for the ontrolling shareholder. More important, in hapter 8 below we propose a way to test out hypothesis, a test of whih results ould onfirm whether we are right in assuming that signifiant information is not being ommuniated. 8. Empirial Impliations 8.. Explanatory ower There is a growing body of empirial work on ross-listing. Some of it supports the bonding hypothesis. For instane, firms that ross-list exhibit positive abnormal returns around the announement date of a U.S. ross-listing. More importantly, the higher the obligations that the firm assumes, the stronger the prie reation to a ross-listing announement (Miller (999. Lastly, it was shown that firms that ross-list have lower

23 ontrol premia and that ontrol premia of firms that ross-list derease upon ross-listing (Doidge (004. Indeed, the evidene suggest that the level of bonding in the U.S. is higher than it is in the foreign ountries from where firms typially ross-list. Yet, even though the bonding hypothesis is reonilable with most of this evidene some evidene suggest that it annot serve as an exlusive explanation for ross-listing. First, ross-listing has been shown to adversely affet the value of domesti non-ross-listed rivals of ross-listed firms (see Melvin and Tonone (004, Lee (004. These results are not onsistent with the bonding hypothesis as an exlusive explanation for ross-listing, sine bonding by peers does not affet the bonding of firms that do not ross-list. Rather they suggest that some form of signaling is happening in addition to bonding. At first glane these results seem to be onsistent with other signaling explanations for ross-listing suh as signaling of information related to the value of the firm (Fuerst (998 or of growth opportunities (Coffee (00, Melvin and Tonone (004. Yet, the negative prie reation seems to be stronger in ountries with weak minority protetion, that is, with high ageny osts (Melvin and Tonone (004, whih suggests that the information that is being signaled is related to private benefits of ontrol rather than firm value. Seond, the strong prie reation to ross-listing also suggests that other things are going on in addition to bonding. The extent to whih ross-listing effetively redues the extration of private benefits is limited. Foreign firms are exempt from dislosing important information (Liht (003 5 and fae relatively low and even negligible enforement, both from publi and private agents (Siegel (00. 6 Given these limitations the prie reation seems to be too strong to reflet merely bonding. Third, many firms do not ross-list and the deision to not ross-list is orrelated with the level of ontrol rights (Doidge, Karolyi, Lins, Miller, and Stulz 006. The signaling of private benefits hypothesis as shown above, is reonilable with the entire body of evidene. It predits that the value of firms that remain in loal markets should derease beause of the signal that their managers extrat lower private benefits of ontrol (orollary 3. It also predits a positive prie reation to ross-listing that is higher than the effiieny gains from bonding, sine under this hypothesis the prie reation reflets the sum of the effiieny gains from bonding and the information to the market that this is a firm with less private benefits of ontrol (orollary. Lastly, it predits that less ontrolling shareholders will ross-list than managers sine while the opportunity that the bonding provide to signal low private benefits of ontrol strengthen managers motivation to ross-list it weakens ontrolling shareholders motivation to ross-list (orollary & orollary 5. Thus while eah of the existing theories is onsistent with some of the evidene but is not able to explain all of it, the signaling of private benefits hypothesis is the only theory that is onsistent with the entire body of evidene. 8.. Testable reditions 5 Foreign issuers are exempt from dislosing material transations with insiders and are allowed to dislose aggregate remunerations and options. (Liht ( Siegel s study finds that from the SEC ated only against five firms listed on ADRs, and that from only twenty five private suits were initiated against foreign firms.

24 In this part we also offer a way to distinguish our hypothesis from other explanations for ross-listing. The signaling of private benefits of ontrol hypothesis suggests that one ontrolling shareholders and managers ross-list the market learns that these ontrolling shareholders and managers have lower private benefits of ontrol while ontrolling shareholders and managers that remain in their home markets have higher private benefits of ontrol. Thus, following ross-listing of firms the ontrol premium of their peers that deide not to ross-list should inrease as predited in orollary 4. To illustrate, assume for example that in a foreign market half of the ontrolling shareholders extrat 0% of firm value as private benefits of ontrol and the other half extrats 30%. In suh a market, in the absene of additional information, buyers will be willing to pay a premium of maximum of 0% for a ontrol blok. One ross-listing beomes a viable option however, if the ontrolling shareholders that extrat 0% hoose to ross-list then potential buyers should be willing to pay 30% premium for a ontrol blok of firms that did not ross-list. An additional predition of our analysis is that upon ross-listing by peers as a result of the inreased ontrol premium we should see more transations in the form of sells of ontrol bloks in the foreign markets. When both types are in the same market sine investors will pay only a ontrol premium of 0% the type that extrats high private benefits of ontrol may be relutant to sell its blok. After a wave of ross-listing, however, sine buyers would be willing to pay more for ontrol bloks of firms that do not ross-list, we should see more ontrol blok sales in firms that do not ross-list. Indeed in a joint work initial results seem to support this onlusion. We find that the frequeny of sales of ontrol bloks inreases after firms ross-list (Barzuza, Smith and alladares ( Summary of Empirial Impliations The following tables summarize our empirial preditions Comparison reditions by Existing Theories The following table ompares the preditions of the signaling of private benefits hypothesis to the preditions of the bonding hypothesis and the preditions of other signaling theories. Eah of the top ells ontains preditions with respet to ross-listed firms and eah bottom ell ontains preditions with respet to the non ross-listed firms. 7 7 For signaling theories based on firm value or growth opportunities see referenes ited in supra note. 3

25 Cross-Listed Firms Bonding ypothesis (Coffee, Stulz - Inrease in firm value - Derease in ontrol premium Signaling of Firm alue or Growth Opportunities ypotheses (Fuerst, Blass and Yafe, Melvin and Tonone - Larger Inrease in firm value than under bonding hypothesis - Derease in ontrol premium - Managers have higher motivation to ross-list than ontrolling shareholders Signaling of rivate Benefits ypothesis - Larger inrease in firm value then under bonding hypothesis and other signaling hypotheses - Larger derease in ontrol premium than under bonding hypothesis - Managers have higher motivation to ross-list than ontrolling shareholders Non Firms Cross-Listed - Nothing happens - Derease of value of shares - Derease of value of shares, whih is larger in ountries with weak minority protetion - Inrease of ontrol premium - Inrease in the frequeny of sales of ontrol bloks Comparison reditions for alues of Shares and Control remiums The following Table shows what existing theories predit should happen to share value and ontrol premium of firms that ross-list and firms that don t ross-list upon a ross-listing event. Eah ell ontains a predition and the theories that support suh a predition. As the table shows sine the preditions that the ontrol premia and frequeny of sales will inrease among firms that do not ross-list are supported only by our hypothesis it an provide a test, as we offered, to distinguish our hypothesis from other existing explanations. 4

26 Cross-Listed Firms alue of Shares alue of Control remium Bonding Signaling of value Signaling of growth Signaling of private benefits Bonding Signaling of private benefits Frequeny of Control Blok Transations Signaling of value Signaling of growth Signaling of private benefits Same Bonding Non Firms Cross-Listed Can t Determine Signaling private benefits of Signaling of value Signaling of growth Signaling of private benefits Signaling of private benefits Signaling private benefits of Same Bonding Same Bonding Signaling of value Signaling of growth Can t Determine Signaling of value Signaling of growth Same Bonding 9. Impliations 9.. Impliations for the Competitiveness of U.S. Capital Markets 5

27 In a new study Luigi Zingales found that the U.S. ompetitiveness in attrating rosslisting has dereased following the enatment of the Sarbanes-Oxley At and an inrease in enforement (Zingales ( Whether or not these results suggest that the U.S. markets offer exessive bonding is debated. 9 Following Zingales study the Committee on Capital Markets Regulation has released an interim report reommending easing regulation and enforement in ertain fields in order to keep U.S. apital markets globally ompetitive. 30 Our study suggests that offering a weak bonding rather than a strong one may help the U.S. apital markets to attrat firms as the interim report suggests. The signaling of private benefits hypothesis shows that while the opportunity to bond may enourage managers to ross-list it atually disourages ontrolling shareholders that plan on selling their ontrolling bloks from ross-listing. As a result, weak bonding, that may attrat also the ontrolling shareholders is likely to result in more ross-listings than a strong bonding would. The forgoing does not mean, however, that a weak bonding is also desirable from a normative point of view. In fat, the finding that a weak bonding may be more suessful than a strong one is a result of ontrolling shareholders private inentives to make ineffiient hoies. As the following part shows, this finding suggests that a ompetitive market for seurities law may lead foreign ountries to adopt inadequate standards of dislosure. 9..Impliation for the Desirability of International Competition in Seurities Law Sholars have previously advoated furthering opening the international seurities markets for ompetition (Choi and Guzman (998 Romano (00, 3 others opposed the idea of ompetition in seurities law suggesting that it may lead to a rae to the bottom (Fox (997. John Coffee suggested that instead of observing a rae to the bottom or a rae to the top we may observe two different markets one with a high level of dislosure that aters mostly to managers and one with a low, inadequate, level of dislosure that aters mainly to ontrolling shareholders (Coffee 00. Coffee explanation for this trend is based on the bonding hypothesis: ontrolling shareholders are looking for lower standards of dislosure, he suggests, sine bonding limits them from extrating private of ontrol. In our view, as explained above, the mere fat that bonding limits ontrolling shareholders from extrating private benefits of ontrol does not suggest that they would look for signifiantly lower standards than managers, sine bonding also limits managers extration. 3 Controlling shareholders may look for lower standards, we suggest, sine 8 Zingales has found that the U.S. share in the number of global IOs, defined as IOs that are not in the domesti markets, fell from 37% in 000 to 0% in See igh and Low Finane: S.E.C. to Firms: Keep Money, Forget Rules Wall Street Journal, (De See Interim Report of the Committee on Capital Markets Regulation (November 30, 006. The report however also suggests inreasing regulation with respet to ertain issues. For instane the report suggests the U.S. should strengthen shareholder rights. 3 Inside the US aul Mahoney has offered to enourage ompetition in seurities law by devolving legislation authorities to exhanges (Mahoney For a more detailed analysis of Coffee s distintion between manages and ontrolling shareholders see part _ above. 6

28 stiking to low standards when other firms ross-list onvey private information that ould inrease the ontrol premium that potential buyers would pay for their blok, ontrol premium whih managers don t get. Moreover, though we do not analyze this diretly, our analysis may suggest that the option to ross-list may push the ontrolling shareholders that do not ross-list to seek a worse legal regime than the one they have been governed with. One the option to separate exists, ontrolling shareholders that extrat high private benefits of ontrol may want to sharpen the distintion between themselves and the other ontrolling shareholders, those that extrat low private benefits of ontrol. These preditions are onsistent with the emergene of the London Stok Exhange, as a major ompetitor for the NYSE. The LSE whih offers more lax standards of dislosure is the main benefiiary of the derease in ross-listings on U.S. exhanges. In the period the study overs the LSE s market share went up from 5% to 5%. 33 Sine the low level of dislosure is expeted to be inadequate, our analysis suggests that some form of a uniform international regulation sheme may be desirable in order to overome the ineffiienies in the low dislosure markets. 9.3.Impliations for the Debate over Convergene Our results also have impliations for a line of literature that asks whether private ontrating ould be ounted on to lead to onvergene toward the same orporate governane paradigm, either in the formal sense, that is onvergene of legal rules (ansmann and Kraakman (00 or onvergene in the funtional sense, that is onvergene of performane (Gilson (00. As was pointed out path dependeny, due to sunk osts, network externalities, omplementarities, endowment effets and multiple optima and rent seeking may forestall onvergene (Bebhuk and Roe (999. This artile suggests that a omplete onvergene is not likely to happen. While asymmetri information may enourage managers to onverge ontrolling shareholders would often benefit from remaining in a separating equilibrium that exposes them as bad types. As a result, we should expet to see some ontrolling strutures that do not onverge neither in the atual nor in the funtional sense. Moreover, though we do not analyze it diretly this artile lays the ground for an argument that some form of divergene, rather than onvergene, may our. One they have the opportunity to separate and distinguish themselves, ontrolling shareholders that extrat high private benefits of ontrol may want to further distinguish themselves and strengthen the signal with respet to the differenes in extration between them and the other ontrolling shareholders that annot extrat large private benefits of ontrol. They an do that by opting for a more lenient regime than the one they ve had so far. 9.4.Impliations for the Desirability of Regulation in Corporate Law Beyond the ross-listing question our analysis has broader impliations for the desirability of legislating mandatory orporate law. First, the analysis suggests that some managers would often limit their opportunities to extrat private benefits of ontrol at the midstream stage of the firm s life. Managers may take this kind of ommitment in order to reveal that they belong to the good type, the one that extrats low private benefits of 33 See Zingales (006 at p. 6. 7

29 ontrol (in a separating equilibrium, or to hide that they belong to the worse type, the one that extrats high private benefits of ontrol (in a pooling equilibrium senario. At the same time, the paper also reveals an opposite tendeny with respet to ontrolling shareholders. The effet that inentivizes managers to limit their private benefits extration inentivizes ontrolling shareholders to expand their extration opportunities. Thus, our analysis suggests that the onflit between ontrolling shareholders and minority shareholders may all for more regulation than the onflit between managers and dispersed shareholders. 0. Conlusion and Agenda for Future Researh rivate benefits of ontrol are onsidered to be a main fore in orporate finane and orporate law. By their very nature private benefits of ontrol are unobservable. Managers and ontrolling shareholders an extrat private benefits of ontrol primarily when those are not verifiable. As a result it is plausible to assume that managers and ontrolling shareholders attempt to signal some information about the private benefits of ontrol that they extrat. This paper applies this framework to the deision to ross list. Fousing on ross-listing deisions this paper has shown that while managers may use the deision to ross-list to signal low extration of private benefits of ontrol, ontrolling shareholders may use the deision to not ross list to signal high private extration of benefits of ontrol. The bonding hypothesis is the dominant hypothesis for ross-listing. Our approah has shown that bonding does not always serve as an enouragement to ross-list. Atually, ounter intuitively, ontrolling shareholders may ross-list despite of the bonding rather than beause of it. Though this paper fouses on ross-listing we believe that our framework ould have impliations for other lines of literature suh as the likelihood of onvergene to one orporate governane struture and rules and the desirability of regulating managers and ontrolling shareholders. The omparison between dispersed shareholders and ontrolling shareholders strutures has beome one of the most important subjets in orporate law (Gilson 006. Further researhing the path of the differenes in the motivation of managers and ontrolling shareholders may prove valuable. This is even more true in light of the urrent wave of going private transations that may result in a signifiant ratio of firms with ontrolling shareholders. Lastly, our analysis ould have impliations also for other deisions in the midstream stage of firm life. Finanial eonomis literature has suggested that in this stage firms adopt different devies to signal future profitability. This signaling story was adopted to explain dividend distribution (Miller and Rok (985, order of raising apital whih is also known as the peking order (Myers (984, Myers and Majluf (984 and other deisions. Yet, the evidene does not ompletely support these explanations. 34 In the studies that assess these theories, however, firms with managers and firms with ontrolling shareholders were bundled together. Our model suggests that these two groups should be treated separately sine they are expeted to at differently as a result of 34 For instane, hanges in dividend poliy do not seem to predit hanges in growth of earnings (Deangelo, Deangelo and Skinner (996, Benartzi, Mihaeli, and Thaler (997 and finanial deisions often violate the peking order model s preditions as equity issues and repurhases are ommon (Fama and Frenh (005. 8

30 asymmetri information about the extration of private benefits of ontrol. For instane, our hypothesis would predit that firms with ontrolling shareholders should tend to distribute less dividends than firms in whih ownership is dispersed. This predition seems to be onsistent with the evidene that firms in ommon law ountries distribute signifiantly more dividends than firms in ivil law ountries (La orta, Lopez-de- Silanes, Shleifer and ishny (000 as dispersed ownership is muh more ommon in the former than the latter. The literature in orporate finane has long been using asymmetri information models to explain deisions by managers and ontrolling shareholders in the midstream stage. These models fous on firm value rather than on the extration of private benefits of ontrol. Our model suggests that reognizing that managers and ontrolling shareholders have private information regarding the extration of private benefits of ontrol is a researh path that may lead to new results. Referenes Barlay, Mihael J. and Clifford G. olderness, (989 "rivate Benefits from Control of ubli Corporations." Journal of Finanial Eonomis 5, Bebhuk, Luian A., (00 Asymmetri Information and the Choie of Corporate Governane Arrangements, arvard Olin Disussion aper No Bebhuk, Luian A., (999 A Rent rotetion theory of Corporate Ownership and Control, NBER Working aper No. 703 (999. Bebhuk, Luian A., (994 Effiient and Ineffiient Sales of Corporate Control, 09 Quarterly Journal of Eonomis, Bebhuk, Luian A. and Mark Roe, (999 A Theory of ath Dependene in Corporate Ownership and Governane, Stanford Law Review, 5, Benartzi, Shlomo, Rony Mihaely and Rihard Thaler, (997 Do hanges in Dividends Signal the Future or the ast? Journal of Finane 5, Blass, Asher and Yishay Yafeh, (00 agabond Shoes Longing to Stray: Why Foreign Firms List in the United States, Journal of Banking and Finane 5, Burkart, Mihael, Denis Gromb and Fausto anunzi, (997 Large Shareholders, Monitoring, and the alue of the Firm, Quarterly Journal of Eonomis,, Burkart, Mihael, Denis Gromb and Fausto anunzi, (998 Why igher remia rotet Minority Shareholders, Journal of olitial Eonomy, 06, Cho, I., and D. Kreps, David (987 Signaling Games and Stable Equilibria, Quarterly Journal of Eonomis 0,

31 Choi, Stephen J. and Andrew T. Guzman (998 ortable Reiproity: Rethinking the International Reah of Seurities Regulation, 7 Southern California Law Review 90. Coffee, John C. Jr., (999 The Future As istory: The rospets for Global Corporate Convergene in Corporate Governane and Its Impliations, Northwestern University Law Review 93, Coffee, John C. Jr., (00 Raing Towards the Top? The Impat of Cross-Listings and Stok Market Competition on International Corporate Governane, Columbia Law Review 0, De Angelo, arry, Linda De Angelo and Douglas Skinner, (996 Reversal of Fortune: Dividend oliy and the Disappearane of Sustained Earnings Growth Journal of Finanial Eonomis 40, Doidge, Craig, (004 U.S. Cross-listings and the rivate Benefits of Control: Evidene from Dual-Class Firms, Journal of Finanial Eonomis 7, Doidge, Craig, G. Andrew Karolyi, and Rene Stulz, (004 Why Are Foreign Firms Listed In the U.S. Worth More?, Journal of Finanial Eonomis 7, Doidge, Craig, G. Andrew Karolyi, K. Lins, D. Miller, and Rene Stulz, (006 rivate benefits of Control, Ownership, and the Cross-listing Deision Dyk, Alexander and Luigi Zingales, (004 rivate Benefits of Control: An International Comparison, Journal of Finane, Fama, Eugene F. and Kenneth R. Frenh, (005 Finaning deisions: who issues stok? Journal of Finanial Eonomis 76, Foerster, Stephen R. and G. Andrew Karolyi, (999 The Effets of Market Segmentation and Investor Reognition on Asset ries: Evidene from Foreign Stoks Listing in the United States, Journal of Finane 54, Fox, Merritt B., (997 Seurities Dislosure in a Globalizing Market: Who should Regulate Whom, 95 Mihigan Law Review 498. Fuerst, Oren, (998 A Theoretial Analysis of the Investor rotetion Regulation Argument for Global Listing of Stoks, SSRN Working aper, available online at < papers.ssrn.om/sol3/papers.fm?abstrat_id=39599> Gilson, Ronald J., (006 Controlling Shareholders and Corporate Governane: Compliating the Comparative Taxonomy, 9 arvard Law Review 64 30

32 Gilson, Ronald J., (00 Globalizing Corporate Governane: Convergene of Form or Funtion 49 Amerian Journal of Comparative Law 39 Guadalupe, Maria and Franiso erez-gonzalez, (006 "The Impat of rodut Market Competition on rivate Benefits of Control" AFA 007 Chiago Meetings aper Available at SSRN: Iaobui, Edward (004 Toward a Signaling Explanation of the rivate hoie of Corporate Law, Amerian Law & Eonomis Review, 6, Jakson, owell E. and Eri J. an (00 Regulatory Competition in International Seurities Markets: Evidene from Europe in 999-art I Business Lawyer, 56, Kahan, Marel (997 Some roblems with Stok Exhange-Based Seurities Regulation, irginia Law Review, 83, Lang, Mark., Karl. Lins and Darius. Miller (003 ADRs, Analysts, and Auray: Does Cross Listing in the United States Improve a Firm's Information Environment and Inrease Market alue? Journal of Aounting Researh, 4(, Leland, ayne E. and David. yle(977 Informational Asymmetries, Finanial Struture, and Finanial Intermediation Journal of Finane, 3, LEE, DONG W., WY DOES SAREOLDER WEALT INCREASE WEN FOREIGN FIRMS ANNOUNCE TEIR LISTING IN TE U.S.?, WORKING AER (003 available at Liht, Amir N. (003 Cross-listing and Corporate Governane: Bonding or Avoiding? Chiago Journal of International Law 4, Mahoney, aul G. (997 The Exhange as a Regulator, irginia Law Review, 83, MICAEL MELIN AND MAGALI ALERO-TONONE, TE EFFECTS OF INTERNATIONAL CROSS-LISTING ON RIAL FIRMS, WORKING AER (004 available at Miller, Darius. (999 The Market Reation to International Cross- Listings: Evidene from Depositary Reeipts, Journal of Finanial Eonomis 5, Miller, Merton and Kevin Rok (985 Dividends oliy Under Asymmetri Information Journal of Finane 40,

33 Myers, Stewart and N. Majluf (984 Corporate Finaning and Investment Deisions when Firms have Information that Investors do Not ave, Journal of Finanial Eonomis 87-. Nenova, Tatiana, (003 The alue of Corporate oting Rights and Control: A Cross- Country Analysis Journal of Finanial Eonomis 68, agano Maro, Ailsa A. Röell, and Josef Zehner, (00 The Geography of Equity Listing: Why Do Companies List Abroad?, 57 Journal of Finane Reese, William A., Jr. and Mihael S. Weisbah, (00 rotetion of Minority Shareholder Interests, Cross-Listings in the United States, and Subsequent Equity Offerings, Journal of Finanial Eonomis 66, Rok, Edward, (00 Seurities Regulation as Lobster Trap: A Credible Commitment Theory of Mandatory Dislosure, Cardozo L Rev 3, Roe, Mark J., (00 Rents and their Corporate Consequenes, Stanford Law Review 53, Roberta Romano, (00 The Need for Competition in International Seurities Regulation, Theoretial Inquiries in Law 387. Ross, Stephan A. (977 The Determination of Finanial Struture: The Inentive- Signaling Approah, Bell Journal of Eonomis, 8, Siegel, Jordan (00 Can Foreign Firms Bond Themselves Effetively By Renting U.S. Seurities Laws? 5 (MIT, Working aper No. 797, 00, available at themselves_effetively.pdf Stultz, Rene M. (999 Globalization, Corporate Finane, and the Cost of Capital, Bank of Ameria Journal of Applied Corporate Finane,, 8- (Fall 999. Zingales, Luigi, (006 Is the U.S. Capital Market Losing its Competitive Edge? (Working paper 006 3

34 Appendix roof of proposition : Sine < (from expression ( the manager s profits are inreasing in if < (from expression (6. The higher the therefore, the more likely it is that the manager would tend to migrate. The intuition for that result is lear. Managers of firms from whih large private benefits ould be extrated will have more to lose by migrating relative to managers that anyway do not extrat high level of private benefits. roof of roposition : A pooling equilibrium in whih not all of the firms hoose to ross-list needs to be sustained by the following beliefs: if someone deviates it must be a type-l, that is, a type that extrats high private benefits of ontrol. Otherwise, Type- firms might find it profitable to deviate, as a way to identify themselves as Type. These beliefs, however, are not robust to the Cho-Kreps intuitive riterion. 35 Assume a pooling equilibrium on ( (, suh that <. If there exists suh a ontrat with > under whih managers of type-l firms would prefer not to adopt even if adopting it leads them to be reognized as Type- firms and managers of type- firms would prefer to adopt this ontrat if it results in revealing their type. If it is only the managers of type- firms that ould benefit from suh a deviation there is no reason to believe that upon observing suh deviations investors would draw inferenes that it has been done by a manager of a type-l firm. In our ase there is suh a ontrat: Let ( (, be a ontrat that both types offer. Consider the deviation ( ε, δ where ε and δ are positive. An investor would aept it for suffiiently small ε and δ if he believes that it is only Type- that has deviated in this fashion. Sine managers of Type- have less to lose from inreasing they will be willing to aept smaller δ then the one managers of Type-L ompanies would require. As a result, there exists suh a ontrat that violates the intuitive riterion. roof of roposition 3: If managers of type-l ompanies prefer their ineffiient symmetri ontrat ( C L (, on the ontrat ( C (, then if managers of Type- ompanies hoose to ross-list managers of Type-L ompanies would not mimi them even if mimiking them results in the market onsidering them as Type- ompanies. 36 To maximize their wealth in suh equilibrium managers of Type- firms would hoose the best separating ontrat that maximizes their utility subjet to the onstraints that the managers of Type-L firms 35 The intuitive riterion is an established refinement for the perfet Bayesian equilibrium. See Choi and Kreps ( This ondition ensures that the manager of a Type-L firm has no inentive to mimi the manager of a Type- firm. For an explanation why we don t need a requirement that the manager of a Type- firm is better off not pooling with the manages of Type-L firms see note 7 above. 33

35 34 would not wish to mimi them. 37 This would be the ase when the following onstraint is binding: ~ ( ( ] ( [( ( ~ ~ ( ( ~ ~ ( = = = L L L L L L L L L roof of Corollary : Under the symmetri information ase prie reation to ross-listing reflets the effetive derease in b as a result of the ommitment to striter regime: The prie that investors would pay in the symmetri ase under the strit regime is ( =. The prie that investors would pay in the symmetri ase under the lax regime is ( =. The prie differene is therefore SI = Under the asymmetri information ase the prie that investors pay in a separating equilibrium is =. The prie that they would pay in a pooling equilibrium on the lax regime is =. The prie differene is AI =. Sine < then AI SI >. QED. roof of Corollary : 37 In analyzing this equilibrium we fous on the ase in whih both managers osts are suffiiently high so that they would not ross-list under the symmetri information ase, that is, the bonding hypothesis.

36 35 Under the Signaling of rivate Benefits hypothesis managers of Type- firms would hoose to ross-list iff: ( ( > < < < > > ( ( ( ( ( ( ( ( Sine And sine firms an differ in the size of the parameter. All the firms that obey < < ( Reall that in the symmetri ase, under the bonding hypothesis firms will ross-list only if >. ere, however, the ondition ould be satisfied also for <. roof of Corollary 3: The value of the firms that remain in the home market before ross-listing by peers ours b = = ( 0 The value of the firms that remain in the home market after ross-listing ours by peers b L = = ( Sine L C C > then 0 >

37 roof of roposition 4: If the managers of Type-L firms prefer the pooling ontrat ( (, to their symmetri information ontrat ( C L (, then the managers of type- firms have no room for signaling. The managers of Type- firms therefore are ompelled to pool with the managers of Type-L firms. Given that they are fored to pool the managers of Type- firms would rather offer a ontrat that expose them to less liability, yet, unfortunately suh an offer would be interpreted by investors as having been made by the managers of Type-L ompanies. And if being identified as Type-L wasn t profitable for Type-L themselves it would not be profitable for Type- who gain less from hoosing a lax regime. roof of roposition 5: See proof of proposition. roof of roposition 6: The proof here is similar to the proof of proposition. A pooling equilibrium in whih not all of the firms hoose not to ross-list, that is a pooling equilibrium on > needs to be sustained by the following beliefs: if someone deviates it must be a ontrolling shareholder of a type- firm, that is, a type that extrats low private benefits of ontrol. Otherwise, it would be profitable for Type-L to deviate to a lower regime with < sine by deviating he inreases its private benefits and also reveals his type. Remember that in the ase of a sell of a ontrolling blok a ontrolling shareholder of Type-L firm gets a better prie than a ontrolling shareholder of a Type- firm. These beliefs however are not reasonable under the Cho-Kreps intuitive riterion if there exists a ontrat with < whih ontrolling shareholders of type- firms prefer not to adopt even if adopting it would lead them to be reognized as Type-L firms and ontrolling shareholders of type-l firms prefer to adopt if it will result in revealing their type. ut differently, if it is only the ontrolling shareholders of type-l firms that ould benefit from suh a deviation there is no reason to believe that upon observing suh a deviation investors would draw inferenes that it has been done by a ontrolling shareholder of a type- firm. In our ase, there is suh a ontrat: Let ( (, be a ontrat that both types offer. Consider the deviation ( ε, δ where ε and δ are positive. From 4 the ontrolling shareholder will deviate iff ( ( ( q > ( q That is iff: ( ( > ( q roof of Corollary 4: 36

38 The value of the blok of firms that remain in home market before their peers ross-list ( C = 0 The value of the blok of firms that remain in home markets after their peers ross-list C ( L = sine > > L then C C 0 As a result, some ontrolling shareholders might benefit from signaling that they extrat relatively large private benefits of ontrol. roof of Corollary 5: Controlling shareholders of type will hoose to ross-list if and only if 37

39 38 [ ] ( ( ( ( ( ( ( ( ( [ ] ( ( [ ] ( ( [ ] ( ( ( [ ] > = < < < < < > > ( ( 0 ( ( ( ( ( ( ( ( ( T T T B B C C q q then q q q if q q q q q q q