What Makes the Bonding Stick? Testing the Legal Bonding Hypothesis

Amir Licht is Professor of Law at the Interdisciplinary Center Herzliya, Israel. This post is based on a recent article, forthcoming in the Journal of Financial Economics, by Professor Licht; Christopher Poliquin, a doctoral student at Harvard Business School; Jordan Siegel, Associate Professor of Strategy at the University of Michigan Ross School of Business; and Xi Li, Associate Professor at Hong Kong University of Science and Technology.

Securities fraud class actions are a key feature of the US regime of corporate governance. Firms from all around the world that cross-list on US markets consequently become subject to this regime. While some countries endeavor to imitate it, others prefer to shun this mode of private enforcement. In our article, forthcoming in the Journal of Financial Economics, we use the US Supreme Court case in Morrison v. National Australia Bank as a natural experiment to assess the role and effect of this enforcement mechanism. We find surprising evidence that suggests implications for firms and law-makers alike.

Foreign firms that list on US stock exchanges experience a range of positive outcomes, but the mechanisms that produce these outcomes are still debated. Specifically, it is unclear whether US exchanges attract firms because a US cross-listing signals a credible commitment to full disclosure by making a firm subject to US legal enforcement, an argument known as the legal bonding hypothesis. Alternatively, a US cross-listing may facilitate informal reputation building, an argument known as the reputational bonding hypothesis. Both mechanisms are theoretically plausible and they could operate in tandem, making it empirically difficult to disentangle their effects.

In Morrison, argued and decided in 2010, the US Supreme Court overturned forty years of precedent to dramatically shrink the legal rights of investors in non-US firms that cross-list on US markets. Investors in such firms who trade their securities on non-US markets lost their right to file or join a US class action in case of fraud. By restricting such legal enforcement to securities traded in the United States, Morrison limited firms’ potential liability in class action lawsuits, which is routinely invoked as a central component of legal bonding. Such a massive and unanticipated change in the law of securities fraud is nearly unprecedented.

We exploit this legal event to test the legal bonding hypothesis. The exclusion of non-US trades makes for smaller classes of eligible plaintiffs, lower expected damage awards and settlements, and lower attorney fees, all factors that fuel class actions. If exposure to US class actions facilitates value-creating legal bonding, the shrinkage of this type of civil liability should elicit negative market reactions. These reactions should be more pronounced for firms with greater non-US trading volume and firms with weaker home-country investor protection. Such firms presumably lose more of the advantages of using the US civil liability regime to credibly commit to compliance.

We first examine the stock returns of a comprehensive sample of US-listed firms in both US and home markets around the date of oral argument, when the Court’s new stance emerged. Contrary to the prediction of the legal bonding hypothesis, we find significantly positive or insignificant abnormal returns. The abnormal returns are particularly positive for firms with above-median non-US capitalization—that is, the very firms that the Court most extensively excluded from the US anti-fraud liability regime. Moreover, the abnormal returns exhibit significant negative relations with certain measures of home-country institutional quality (and no significant relations with others). In other words, the weaker the institutions in firms’ home markets, the more positively markets reacted to the dilution of US anti-fraud liability.

Several tests of longer-term effects on reporting practices show no change in foreign firms’ tendency to engage in earnings management or to switch auditors, which could indicate tensions over corporate candor. We also fail to observe more frequent earnings surprises, which would suggest less transparent and informative disclosure. We do observe a slight decrease in the incidence of class actions against Morrison-affected foreign firms and no change in the frequency of SEC enforcement actions. Finally, we find no changes in the bid-ask spread, as a measure of adverse-selection risk, contrary to the prediction that Morrison should lead to higher spreads that reflect greater opacity.

Analyses at the investor level of price and return differentials and of trading volumes across markets during 2010 suggest that investors did not change their trading patterns by shifting trades to US markets to secure the advantages of the US private enforcement umbrella.

This evidence blends two separate findings and implications. First, the non-negative market reaction calls into question whether the US civil liability regime in fact facilitates legal bonding, and thus whether legal bonding is a primary motivation for cross-listing. The benefits of exposure to the type of US enforcement affected by Morrison appear, on average, to be no greater than the costs. These results go against the legal bonding hypothesis but are consistent with reputational bonding and with market-based accounts of US cross-listing.

Second, the evidence may shed light more broadly on the use of US-style class actions as a private enforcement mechanism against securities fraud. Our natural experiment focuses exclusively on cross-listed firms, but it can also be viewed as a clean laboratory in which to assess the efficacy of private enforcement in general. A US-style securities-fraud class action regime could be viewed as a regulatory burden for firms. Viewed through this lens, Morrison relieved cross-listed firms from burdensome legal exposure; the positive link between market reactions and dilution of this regime is consistent with this idea. These results warrant further inquiry into the merits of the prevailing US civil liability regime for US firms and the importance of public enforcement.

The complete article is available for download here.

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