Has Sarbanes-Oxley Led to a Chilling in the U.S. Cross-Listing Market?

By Hong Zhu and Ken Small

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A review of the academic literature points to several motives for cross-listing, including a desire to increase the visibility of the company, to tap into a more liquid market, to signal the company’s strength, or to follow tougher exchange requirements. Cross-listed foreign companies are a boon to U.S. institutional and individual investors because they allow them to take advantage of international diversification without having to trade in a foreign market. Maintaining foreign companies’ presence in the U.S. market would benefit not only the cross-listed foreign companies, but U.S. investors as well.

The current environment invites a dialogue between regulators and accounting professionals regarding SOX’s impact on international cross-listing in the United States. What is needed is further discussion about how the provisions of SOX apply to cross-listed foreign companies, and further investigation into the possibility that SOX has had a chilling effect on cross-listings.

Background

The vast majority of foreign companies choose to cross-list in the United States, using the American Depositary Receipt (ADR) program. An ADR is a negotiable instrument representing an ownership interest in securities of a non-U.S. company. An ADR is issued by a depositary bank in the United States and is backed by a specific number of underlying shares held in a custodian bank. ADRs offer the same rights and benefits for the ADR holders as the underlying shares, and ADRs are specifically designed to facilitate U.S. investors’ purchase, holding, and sale of securities of non-U.S. companies. ADRs are quoted and traded in U.S. dollars, settled according to procedures governing the U.S. market, and are considered U.S. securities. Trading of ADRs rose to 40.1 billion shares ($877 billion) in 2004, up from 4.3 billion shares ($125 billion) in 1992. U.S. institutional investors are responsible for the growing interest in trading ADRs.

ADRs can be issued at four levels. Level I ADRs are traded over the counter as OTC Bulletin Board or Pink Sheet issues. Level IV ADRs are sold in a private placement and their trading is facilitated by PORTAL, the NASD’s quotation system for Rule 144A securities. These two ADRs require minimal SEC registration. Both Level II ADRs (no capital raising) and Level III ADRs (new capital raising) trade on a U.S. stock exchange, require subsequent annual filings (form 20-F) with the SEC, and also need partial (Level II) or full (Level III) reconciliation with U.S. GAAP. Exhibit 1 summarizes the regulatory and reporting requirements for the different ADR options.

Earlier studies (including William Reese Jr. and Michael S. Weisbach, “Protection of Minority Shareholder Interest, Cross-Listings in the United States, and Subsequent Equity Offerings,” Journal of Finanancial Economics, 2002) have examined ADR issuers’ motives for listing in the United States. and categorized them as follows:

• The market segmentation/investor recognition model, where issuers seek to enhance visibility, develop or increase analyst coverage, broaden U.S. investor base, and avoid cross-border barriers;
• The liquidity model, where issuers want to increase liquidity by decreases in transaction costs and increases in trading volumes; and
• The shareholder protection/legal bonding model, where issuers offer increased protection of minority shareholders’ interest by “bonding” themselves to U.S. security law and U.S. GAAP.

Issuing Level II or Level III ADRs entails the above advantages of cross-listing in the United States; they also entail full compliance with SOX.

Required SOX Compliance of ADRs

SOX applies to “issuers,” as defined in section 3 of the Securities Exchange Act of 1934 (Exchange Act), that: 1) have securities registered under section 12 of the Exchange Act; 2) are required to file reports under section 15(d) of the Exchange Act; or 3) file or have filed a registration statement that has not yet become effective under the Securities Act of 1933 and that they have not withdrawn. Because SOX does not distinguish between U.S. and non-U.S. issuers, and does not exempt non-U.S issuers from its reach, the provisions that apply to U.S. issuers also apply to non-U.S. issuers unless they are specifically excluded by a related provision of the Exchange Act or the Securities Act. SOX leaves it to the SEC to determine where and how to apply its provisions to non-U.S. issuers. Certain provisions in the Securities Act and Exchange Act do mandate different treatment for different levels of ADR issuers. As shown in Exhibit 1, Level I ADRs are required to comply with criminal and whistleblower provisions of SOX, and Level IV ADRs are required to comply with criminal provisions of SOX. Both Level II and Level III ADRs must comply fully with all provisions of SOX.

SOX addresses, among other things, financial reporting, CEO and CFO certifications, internal controls, risk management, the composition of audit committees, corporate codes of ethics, whistleblower protection, and attorney conduct (Exhibit 2).

As mandated by Congress, the SEC intended to treat foreign issuers in the same manner as it treats domestic issuers, because, “After all, U.S. investors trading in the U.S. markets are entitled to the same protections regardless of whether the issuer is foreign or domestic” (Ethiopis Tafara, acting director, office of international affairs, SEC, “Speech by SEC Staff: Addressing International Concerns under the Sarbanes-Oxley Act,” June 10, 2003). During the implementation, however, the SEC realized that in some instances it was impossible for some foreign issuers to comply with both the laws of their home country and the terms of SOX. For example, Australian corporate law requires shareholders, as opposed to an audit committee, to select the auditor. Over time, the SEC has had to provide non-U.S. issuers certain accommodations to take into account foreign laws and regulations. For example, the SEC now allows nonmanagement employees to serve as audit committee members, lets shareholders select or ratify the selection of auditors, and permits foreign government representation and controlling shareholder nonvoting representation on audit committees. Cross-listed companies availing themselves of these accommodations must disclose their reliance on the accommodations and their assessment of how such reliance might materially adversely affect the ability of their audit committee to act independently.

The SEC also further extended the compliance dates for non-U.S. issuers regarding internal control (section 404) for an additional year, to the fiscal year ending on or after July 15, 2006. Such exemptions are expected to be rare. In terms of keeping the U.S. stock exchanges attractive to foreign companies and competitive with other world exchanges, most do not believe that the SEC has gone far enough in accommodating non-U.S. issuers under SOX. Exhibit 2 summarizes the effective dates of implementing certain sections of SOX for Level II and Level III ADRs, and Exhibit 3 lists the provisions of SOX. Current accommodations provided by the SEC to Level II and Level III ADRs are highlighted in the shaded cells of Exhibit 2.

Current Movements of ADRs in Response to SOX Compliance Requirements

The following analysis focuses on Level II and III ADRs because they are subject to full SOX compliance, just like their domestic counterparts. Exhibit 4 charts the new cross-listings of Level II and III ADRs on the American Stock Exchange (AMEX), Nasdaq, and the New York Stock Exchange (NYSE), annually from January 1, 1985, to December 31, 2005, and all domestic common-stock listings on the same exchanges over the same period. The data were obtained from JPMorgan Chase and Company.

Decrease in cross-listings. The increase in new U.S. listings and new cross-listings in the mid-1990s was likely due to the positive general economic environment in the United States during that period. Note also the spike in new ADR cross-listings and U.S. listings in 1996, coinciding with the peak of the hot IPO market. The largest annual number of new Level II and III ADR cross-listings also occurred in 1996.

New ADR cross-listings significantly declined after 2000. A decrease from the record-setting new cross-listings of 2000 would be expected, and is evidenced by the 34 new cross-listings in 2001, a number more in line with the pre-2000 increase in new listings. For example, 2003 saw only 12 new cross-listings on the major U.S. exchanges, the lowest number of new cross-listings since 1989. In addition, new Level II and III ADR cross-listings in 2004 and 2005 were at their lowest level since 1992. But what about companies already cross-listed? If SOX compliance costs do indeed outweigh the benefits, then listed firms would be withdrawing from the U.S. market.

Increase in delistings. To better understand the impact of SOX on cross-listed companies’ decisions to delist from the U.S. exchanges, the authors charted the raw number of domestic delistings on the major U.S. exchanges (AMEX and Nasdaq) versus those of Level II and Level III ADRs from 1987 to 2005, in Exhibit 5.

The increase in delistings during 2000 was likely due to the deflation in the market value of the U.S. stock market. A return to normalcy after the roaring 1990s would be expected, but a noticeable shift occurred in 2002: The number of ADR delistings began to increase while the number of domestic delistings began to level off and actually fell in 2005. This provides some evidence that SOX has had a chilling effect on the decision of foreign companies to stay listed in the U.S.

To examine more closely the relationship between new ADR listings and new U.S. security listings on the major U.S. exchanges, the authors calculated the ratio of the two. The authors calculated a similar ratio for delisted stocks. The cross-listing and delisting ratios allow for a comparison of trends in ADR cross-listings and delistings that accounts for general U.S. market trends. For example, if SOX has also decreased new domestic listings or increased domestic delistings, the ADR/domestic cross-listing and delisting ratios will capture these influences.

As seen in Exhibit 6, the new cross-listing/new domestic listing ratio reaches its maximum value of 0.165 in 2001. Note the pronounced decline in the new cross-listing/new domestic listings ratio from 2002 to 2005. The ratio decreased from 2001 to 2005, with the 2005 value reaching a 10-year low.

On the other hand, the delisting ratio increases in each year over the 2002-to-2005 period. The ratio almost doubles, increasing from 0.047 in 2000 to 0.085 in 2005. This suggests, after the passage of SOX, foreign companies are choosing to delist at an increasing rate compared to their domestic counterparts. The increase in foreign delistings, together with the decrease in new cross-listings, provides evidence that SOX has weakened the competitiveness of the U.S. as a cross-listing venue.

Analyzing the Findings

Now is the right time to look at SOX’s impact on international companies’ willingness to cross-list on the major U.S. exchanges and their propensity to delist from U.S. exchanges. The authors’ analysis indicates that the passage of SOX has had a detrimental impact on international companies’ decisions whether to cross-list in the United States. The authors find that new ADR cross-listings relative to new domestic listings are at their lowest level in 16 years. This finding, coupled with the fact that ADR delistings relative to domestic delistings are at their greatest level in the past 16 years, reinforces the belief that SOX has had a chilling effect on cross-listings in the United States. Although the authors caution that a definitive answer to questions surrounding the impact of SOX on delisting and cross-listings can come only after many years of careful analysis, the preliminary data seem to suggest a negative impact on the competitiveness of U.S. exchanges in the global market.

Hong Zhu, PhD, is an assistant professor in the department of accounting, and Ken Small, PhD, CFA, FRM, is an assistant professor in the department of finance, at the Sellinger School of Business and Management at Loyola College in Maryland, Baltimore, Md.