Changes in risk of foreign firms listed in the U.S. following Sarbanes-Oxley

J. of Multi. Fin. Manag. 19 (2009) 193–205

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Changes in risk of foreign firms listed in the U.S. following Sarbanes-Oxley Aigbe Akhigbe a, Anna D. Martin b,∗, Takeshi Nishikawa b a b

College of Business Administration, Department of Finance, University of Akron, Akron, OH 44325, United States Tobin College of Business, Department of Economics and Finance, St. John’s University, Queens, NY 11439, United States

a r t i c l e

i n f o

Article history: Received 27 June 2008 Accepted 23 November 2008 Available online 28 November 2008 JEL classification: G20 G28 Keywords: Sarbanes-Oxley Risk effects Foreign firms

a b s t r a c t This study investigates the changes in the riskiness of foreign firms listed in the U.S. following the passage of the Sarbanes-Oxley Act (SOX), legislation aimed at calming investor fears. While capital market measures of risk increase on average over a shorter-term period, total and unsystematic risk measures decrease on average over a longer-term period. Finding longer-term decreases in these risk measures is consistent with reductions in investor uncertainty. Further cross-sectional analyses show that foreign firms considered to be less uncertain at the time of SOX passage received the greatest risk reductions in the post-SOX period. Thus, it appears that the less uncertain foreign firms especially benefited from the heightened awareness and investor focus that occurred in conjunction with the passage of SOX. © 2008 Elsevier B.V. All rights reserved.

1. Introduction The Sarbanes-Oxley (SOX) corporate reform legislation was enacted in July 2002, with the goals of restoring investor confidence and integrity of the U.S. financial markets through its enhanced governance and disclosure provisions.1 At the time of its passage, this law received complaints of U.S. economic imperialism because of its applicability to foreign firms listed on U.S. exchanges and caused concerns over the possibility that foreign issuers may leave U.S. capital markets.2 It is plausible that U.S. legislators chose not to exclude foreign firms due to the extraordinary high level of investor anxiety and concerns over accounting practices also occurring within non-U.S. firms (e.g., Vivendi in France,

∗ Corresponding author. Tel.: +1 718 990 7383; fax: +1 330 990 1868. E-mail addresses: [email protected] (A. Akhigbe), [email protected] (A.D. Martin), [email protected] (T. Nishikawa). 1 See Coates (2007) for a discussion of SOX goals and a more complete review of its provisions. 2 For example, see “Long arm of the U.S. regulator,” in the March 10, 2005 issue of the Financial Times. 1042-444X/$ – see front matter © 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.mulfin.2008.11.002

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Elan in Ireland, Parmalat in Italy, Swiss Life in Switzerland).3 Shin (2007) believes the legislators were more concerned with the fallout from the Enron and WorldCom scandals than with the prospective complaints from foreign listed firms. Furthermore, Shin (2007) discusses the relatively narrow exceptions eventually provided to foreign issuers when they faced conflicting requirements between their home country and the U.S. In this study, we examine changes in capital market risk measures of foreign firms listed in the U.S. that occur following the passage of SOX. While there have been studies published that focus on the impact of SOX on foreign firms (Litvak, 2007; Shin, 2007), these studies have not examined the risk implications. Litvak (2007) finds adverse wealth effects for foreign issuers in the U.S. on the expectation of net compliance costs; SOX benefits are not expected to exceed its costs.4 Shin (2007) examines the number of foreign-listed firms in the U.S. and does not find a drastic change in the post-SOX period. Based on these studies, it appears that the net costs of SOX to foreign issuers were not sufficient to warrant delisting. To the extent that the law has contributed to calming investor fears, investment risk would be expected to be lower in the post-SOX period for foreign firms listed in the U.S. With lower risk in the post-SOX period, it can be argued that these firms have received an indirect benefit that has not been explicitly considered in these previous studies. Furthermore, given the controversy surrounding the applicability of SOX to foreign issuers, it is useful to assess whether foreign issuers achieved some risk reduction benefits in the post-SOX period. There have been two studies published that examine the risk shifts in the post-SOX period. Focusing on U.S. firms, Akhigbe et al. (2008) find increased risk in the immediate period following the passage of SOX and attribute the increased risk to the mandatory nature of the governance and disclosure requirements. They also report statistics that provide some evidence of decreased risk over a longerterm period, possibly reflecting the more fundamental effects of the legislation. Focusing on financial services firms, Akhigbe and Martin (2008) show that the increased risk measures in the immediate period after SOX passage and the decreased risk measures over a longer time frame after SOX passage vary with governance and disclosure characteristics. We evaluate the changes in capital market risk measures in the post-SOX period for 417 foreign firms listed in the U.S. from 47 countries. Interestingly, we find that capital market risk measures increased in the more immediate period following the passage of SOX, which does not support the idea that the legislation helped calm investor fears. However, consistent with reductions in investor uncertainty, we find that total risk and unsystematic risk measures decreased over a longer-term period of time. Our cross-sectional analyses characterize these longer-term risk reductions that likely reflect the fundamental effects of the legislation. We show that foreign firms considered to be less uncertain at the time of SOX passage experienced the greatest risk reductions in the post-SOX period. It appears the heightened awareness and investor focus that occurred in conjunction with the passage of SOX translated into lower capital market risk measures for those foreign firms with less uncertainty. More specifically, we find that the risk reductions vary with bid-ask spread, trading volume, tax haven status, governance score, leverage and firm size. The remaining paper is organized as follows. Section 2 discusses the potential risk shifts in the post-SOX period. Section 3 describes the sample and reports the changes in capital market risk measures, and Section 4 presents the cross-sectional results on the risk shifts. The summary is provided in Section 5. 2. Potential risk shifts in the post-SOX period There has been some past research on the risk implications of the Sarbanes-Oxley legislation. Following Akhigbe and Martin (2008) and Akhigbe et al. (2008), we consider shifts in capital market risk 3 Ivaschenko (2004) shows that Canadian firms listed in the U.S. were increasingly risky following Enron’s bankruptcy in December 2001. This finding helps to substantiate that the heightened investor concerns extended beyond U.S. firms to foreign firms listed in the U.S. 4 Other studies that have also focused on the wealth effects associated with the legislation for U.S. firms include Engel et al. (2008), Li et al. (2008), Zhang (2007), Rezaee and Jain (2006), Chhaochharia and Grinstein (2007), and Akhigbe and Martin (2006).

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measures that may occur in the post-SOX period. More specifically, shifts in (i) market risk, (ii) total risk, and (iii) unsystematic risk are estimated in this study and discussed in this section. To the extent that foreign firms listed in the U.S. are largely classified into the same investment category as U.S. firms, we may also find increased risk in the short-term and decreased risk in the longer-term in accordance with the findings of Akhigbe et al. (2008). 2.1. Market risk Based on the theoretical work of Coles et al. (1995), it can be argued that the impact of SOX on market risk is not straightforward. They show that as information is revealed and investor uncertainty is resolved, betas may increase or decrease as they converge to their more appropriate values. Collins and Simonds (1979) find positive and negative beta shifts due to the line of business disclosure regulation that provided more information on operating risk to investors. To the extent that new and credible information is revealed in the post-SOX period with its governance and disclosure requirements, market risk is expected to adjust to its more appropriate value. There are studies that support a positive shift in market risk following the passage of SOX. Jorgensen and Kirschenheiter (2003) develop a model that shows firms are expected to have higher market risk with mandatory risk disclosures. Since SOX includes mandatory governance and disclosure provisions, it can be argued that market risk would increase for those firms that are expected to disclose unfavorable information that had previously not been available. Additionally, the study by Ivaschenko (2004) finds that Canadian firms that are interlisted in Canada and the U.S. had increased market risk following the fraud and bankruptcy at Enron. Ivaschenko believes that negative investor sentiment in the post-Enron period may have influenced the betas to rise. Lastly, John et al. (2005) show that better investor protection is associated with high operating income volatility and provide arguments for stronger governance leading to riskier but value enhancing investments. A reduction in market betas could also be predicted, based on the work of Barry and Brown (1985), as firms improve governance and disclosure, and reduce estimation risk. They theoretically show that firms with relatively little information, thus relatively high estimation risk, have higher systematic risk than in the absence of estimation risk. Furthermore, Cohen et al. (2007) find significant reductions in R&D and capital expenditures in the post-SOX period, which shows reduced risk-taking behavior may result from the increased management accountability and criminal penalties established by the legislation. 2.2. Total and unsystematic risk One prediction is that total and unsystematic risks would decrease after SOX passage, since most research finds stronger governance and disclosure are associated with lower total and idiosyncratic risks, such as fraud risk and default risk. Stock price volatility may be reduced since disclosure may mitigate uncertainty, reduce information asymmetries, and/or reduce heterogeneity of beliefs about the value of the firm. Focusing on the post-1933 Securities Act period with its greater disclosure requirements, Stigler (1964) reports lower variance of common stock price ratios for firms issuing new shares and Simon (1989) reports lower variance of excess returns. McNichols and Manegold (1983) find lower return variability for firms as they begin to disclose more information via interim financial reports. Sengupta (1998) reports a positive association between the disclosure quality and bond ratings, which indicates that total and/or unsystematic risk is perceived to be lower for firms with better disclosure. Bhojray and Sengupta (2003) argue that governance should be positively associated with bond ratings, to the extent that governance mechanisms reduce agency risk and/or induce firms to provide timely disclosures. When examining lower-rated bonds, they provide evidence that governance mechanisms reduce default risk. Anderson et al. (2004) find the cost of debt is lower for firms with greater board independence, larger boards, and fully independent audit committees. Alternatively, there are arguments in support of a positive association between stock volatility and strong disclosure. Stock volatility may be higher due to a greater flow of information that induces price changes, due to more disclosures providing newer data that can be misinterpreted, and due to attracting short-term transient investors. Based on an arbitrage-free economy, Ross (1989) theoretically shows

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Table 1 Sample of foreign firms listed in the U.S. Number of firms

Country

101 44 38 23 19 17 12 12 11 11 129

Canada Israel U.K. Bermuda Japan Netherlands France Chile Australia Mexico Remaining 37 countries

417

Total

This table displays the country of origin of those foreign issuers with adequate stock return and cross-sectional data to be included in the sample. The list highlights those countries with more than 10 sample firms.

that price volatility is influenced by the flow of information. He shows that price volatility is equal to information volatility, otherwise arbitrage is possible. Since prices change in response to information, a greater flow of information may be expected to induce greater volatility. Bushee and Noe (2000) believe that firms with quality disclosures attract short-term transient institutional investors to a greater extent than longer-term investors, which may explain why they find return variability is positively associated with disclosure quality. Botosan and Plumlee (2002) show that quarterly financial statement disclosures are associated with greater stock price volatility, which is consistent with the idea that more frequent disclosures attract transient traders that have a volatility-increasing effect. Zhang and Ding (2006) similarly document increased disclosure to be associated with increased volatility for a sample of Chinese firms. Thus, it may be expected that increased quantity and quality of disclosures are associated with an increase in total risk and idiosyncratic risk following the passage of SOX. Xu and Malkiel (2003) observe that in recent times, institutional investors dominate the market and that there is relatively high turnover in the market. As a result, they argue that institutional trading activities are likely to be coordinated, information will be quickly impounded into prices, and volatility will be higher. Their arguments are reinforced by their empirical work that shows idiosyncratic risk is positively related to institutional holdings. Since SOX requires greater and timelier information disclosure, it is plausible that idiosyncratic risk may increase in the post-SOX period due to the external monitoring and trading activity of institutional investors. 3. Sample and risk shift estimates We identify 417 foreign firms listed in the U.S. that are required to comply with SOX and have the necessary stock return and cross-sectional data available from CRSP and Compustat databases.5 Table 1 displays the number of firms by country of origin. There are a total of 47 countries represented in our sample, with the largest representation of foreign issuers from Canada, followed by Israel and the U.K. SOX is applicable not only to the directly listed foreign firms, but also to the 192 American Depository Receipts (ADRs) in our sample as they are all level II and III ADRs. We estimate changes in capital market measures of market risk, total risk, and unsystematic risk that occur between the pre-SOX period and the post-SOX period, where the pre-SOX period is defined to be prior to any concrete legislative progress towards reform and the post-SOX period is defined to be following its passage. We examine the risk shifts over a shorter-term period using daily stock return

5 All domestic and foreign firms listed in the U.S. with reporting obligations to the U.S Securities and Exchange Commission (SEC) are required to comply with the Sarbanes-Oxley legislation. See Shin (2007) for a discussion on the narrow exceptions eventually provided to foreign issuers when SOX conflicts with their home country requirements.

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data as well as changes over a longer-term period using monthly stock return data. For the shorterterm (longer-term) risk shifts, the pre-SOX period is defined as the 100 days (36 months) preceding the first important event in the legislative process. On 16 April 2002, the U.S. House Financial Services Committee voted on the Oxley bill, which is arguably the first important event in the legislative process leading to the reform legislation (Akhigbe and Martin, 2006; Litvak, 2007).6 We define the post-SOX period for the shorter-term (longer-term) risk shifts as the 100 days (36 months) following SOX passage on 30 July 2002. We acknowledge there were some countries other than the U.S. who also focused on governance regulation, which may make it more difficult or less difficult to detect risk shifts between the preand post-SOX periods for some firms. Because some of the foreign firms experienced increased home country governance regulation prior to SOX and others experienced increased home country governance regulation following SOX, there should be no bias on average that unduly influences our results. For example, the U.K. firms listed on the London Stock Exchange have conformed to the governance provisions of the Combined Code and the Israeli firms listed on the Tel Aviv Stock Exchange have been bound by The Companies Act well before the passage of SOX. On the other hand, the Canadian legislature amended the Ontario Securities Act in 2004, following the passage of SOX, for Canadian firms listed on the Toronto Stock Exchange to have similar provisions to those of SOX. The risk shifts are estimated for each of the 417 sample firms with the approach recently used by Amihud et al. (2002), Akhigbe et al. (2008) and Akhigbe and Martin (2008). The change in market risk that occurs in the post-SOX period is estimated as ˇ2 in the following augmented market model that is generated using OLS over the pre-SOX and post-SOX periods: Rt = ˇ0 + ˇ1 Rmt + ˇ2 ϕt Rmt + et

(1)

where, Rt is the stock return at time t, Rmt is the return on the CRSP equally weighted market index at time t, ϕt is equal to 1 in the post-SOX period and 0 otherwise, ˇ0 is the intercept, ˇ1 is the base market risk over the entire period, ˇ2 is the change in market risk that occurs in the post-SOX period, and is also equal to, ˇ if market risk were separately estimated with the market model over both the pre-and post-SOX periods (i.e., ˇ = ˇ(Post) − ˇ(Pre) = ˇ2 )), and et is the error term at time t. The change in total risk,  2 , is the variance of stock returns over the post-SOX period minus the 2 2 . The change in unsystematic risk,  2 , is the variance of returns over the pre-SOX period, post − pre e variance of residuals from the OLS estimation of the single factor market model over the post-SOX period minus the variance of residuals from the OLS estimation of the single factor market model over 2 2 the pre-SOX period, e,post − e,pre . Table 2 summarizes the risk shift measures. Panel A (Panel B) reports the risk shifts that occur over the shorter-term period (longer-term period). We provide summary statistics for the full sample and for each of the 10 countries that has more than 10 observations in our sample. The null hypothesis that the mean (median) risk shift equals zero is evaluated using the parametric t-test (non-parametric Wilcoxon signed-rank test). In Panel A, across the full sample, we find all three of the risk measures increase significantly over the shorter-term period. This result does not appear to be driven by firms from a specific country. Many of the country subsets show significant increases in all three risk measures. Only minor variations across countries are found, with some negative and significant risk shifts within Israeli and Japanese firms. In Panel B, across the full sample, we see that total and unsystematic risks significantly decline over the longer-term period, while market risk increases over this period. Again, it does not appear that a specific country or group of countries is driving the results. Indeed, the risk shifts are remarkably consistent across the subsets. Only one minor difference is detected, with a negative and significant median market risk shift for Israel.7

6 Zhang (2007) details many events associated with the development and passage of SOX, and not until 16 April 2002 was it clear that legislators were making progress. Additionally, Akhigbe et al. (2008) provide robustness checks on selecting 16 April 2002 as the pivotal date and show the risk shifts are not unduly influenced by confounding events, such as 9/11/01. 7 It can be noted that the quartile distributions by country in Table 2 shows variation in the market risk shifts. Some firms experienced positive market risk shifts while others experienced negative market risk shifts, which is consistent with the work of Collins and Simonds (1979) and Coles et al. (1995).

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Table 2 Summary statistics of foreign firm risk shifts following SOX passage. All firms Panel A: Shorter-term risk shifts Number of firms 417

Israel

UK

Bermuda

Japan

Netherlands

France

Chile

Australia

Mexico

101

44

38

23

19

17

12

12

11

11

0.0805*** 0.0268*** −0.0062 0.0950

0.0472** 0.0269*** −0.0031 0.0771

0.1388* 0.0105 −0.0462 0.1587

0.1258** 0.0303*** 0.0070 0.0911

0.0651 0.0153 −0.0193 0.0398

−0.0153*** −0.0145*** −0.0336 −0.0023

0.0885*** 0.0954*** 0.0256 0.1655

0.2149*** 0.2216*** 0.0991 0.2840

0.0811 0.0209*** 0.0130 0.0502

−0.0050 0.0052 −0.0596 0.0207

0.0179 0.0051 −0.0270 0.0721

Unsystematic risk shift (e2 ) Mean 0.0642*** Median 0.0131*** Quartile 1 −0.0106 Quartile 3 0.0648

0.0270 0.0133*** −0.0100 0.0611

0.1316* 0.0035 −0.0459 0.1586

0.1091** 0.0186*** 0.0000 0.0788

0.0530 0.0061 −0.0480 0.0205

−0.0158*** −0.0166*** −0.0305 −0.0004

0.0415*** 0.0330*** 0.0157 0.0787

0.1588*** 0.1487*** 0.0429 0.2614

0.0778 0.0133*** 0.0066 0.0512

−0.0058 −0.0009 −0.0546 0.0093

0.0052 0.0012 −0.0273 0.0123

Market risk shift (ˇ2 ) Mean Median Quartile 1 Quartile 3

0.1456* 0.1936*** −0.1162 0.5644

−0.3644*** −0.1420** −1.0955 0.2494

0.0662 0.1341 −0.1693 0.3399

−0.1151 −0.1773 −0.3123 0.2783

0.0510 0.2086 −0.1297 0.7460

0.0463 0.0362 −0.3852 0.3300

44

38

0.0404 0.1178** −0.2946 0.5039

Panel B: Longer-term risk shifts Number of firms 417 Total risk shift (␴2 ) Mean Median Quartile 1 Quartile 3

101

−0.6477*** −0.6267*** −0.9500 −0.2869

0.2616 0.4132 −0.0527 0.7411

23

19

17

12

12

11

11

0.4265*** 0.4982*** 0.0749 0.7251

0.4063** 0.5241** 0.0963 0.7598

−1.4648*** −0.6027*** −2.0174 −0.0078

−2.0911*** −0.4107*** −3.0043 0.0464

−2.4391** −1.9766*** −4.6000 −0.5404

−1.3457** −0.6445*** −0.8761 −0.0896

−3.0659*** −1.2524*** −3.4603 −0.5086

−1.0410*** −0.6899*** −1.3108 −0.4361

−1.0271 −0.5591 −0.8482 0.1395

−1.2573 −0.0460 −1.6239 1.5452

−0.0706 −0.0626 −0.5109 0.1399

−0.4079*** −0.5164*** −0.7566 −0.1704

−1.6404*** −1.7069*** −2.5210 −0.6894

Unsystematic risk shift (e2 ) Mean −1.1087*** Median −0.5868***

−1.6910*** −0.6230***

−1.1899 −1.3712***

−1.0465** −0.6215***

−2.8643*** −1.0524***

−0.9824*** −0.6647***

−0.8854** −0.6419***

−1.0984 −0.2281

−0.0475 −0.0661

−0.2267 −0.3643**

−1.2942*** −0.7135***

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Total risk shift (␴2 ) Mean Median Quartile 1 Quartile 3

Canada

−1.6994 −0.0371

Market risk shift (ˇ2 ) Mean 0.1348*** Median 0.2185*** Quartile 1 −0.2467 Quartile 3 0.6366

−2.5643 −0.0537

−3.3019 0.3649

−0.9611 −0.1015

−2.5301 −0.5868

−1.1426 −0.3802

0.0445 0.2903** −0.3301 0.6886

−0.2470 −0.2913** −0.9751 0.2544

0.2210 0.1632** −0.1558 0.5549

0.0483 0.2110 −0.3968 0.6546

0.1628* 0.2146* −0.0281 0.3771

−1.0123 0.0015 0.5530** 0.5483** 0.3449 0.9376

−1.2076 0.8773 0.4666 0.5166 0.1302 1.1178

−0.3015 0.0487 0.2241** 0.1468** 0.0092 0.4759

−0.6943 −0.1329

−2.3484 −0.6683

−0.0299 0.0695 −0.2606 0.3888

−0.1657 −0.0506 −0.5860 0.2880

This table shows summary statistics for the shifts in total risk, unsystematic risk, and market risk following the passage of the SOX calculated using shorter-term risk shifts in Panel A and longer-term risk shifts in Panel B. The pre- and post-SOX periods include: (i) 100 days prior to its development and 100 days following its passage in Panel A, and (ii) 36 months prior to its development and 36 months following its passage. Total risk shift,  2 , is the difference in stock return variances between the pre- and post-SOX periods. The change in unsystematic risk, e2 , is the difference in error variances that are generated from pre- and post-SOX market models. The change in market risk is ˇ2 estimated over the pre- and post-SOX periods as follows: Rt = ˇ0 + ˇ1 Rmt + ˇ2 ϕt Rmt + et where Rt is the stock return, Rmt is the market return, ϕt is equal to 1 in the post-SOX period and 0 otherwise, ˇ0 is the intercept, ˇ1 is the pre-SOX market beta, and et is the error term. *** , ** , and * indicates the mean (median) risk shifts are significance at the 1%, 5%, and 10% levels, respectively, based on the t-test (Wilcoxon signed rank test).

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Quartile 1 Quartile 3

199

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Finding increased risk in the more immediate period following the passage of SOX but reduced total and unsystematic risks in the longer-term period shows that investors reacted similarly to the foreign firms listed in the U.S. as they did to U.S. firms (e.g., Akhigbe et al., 2008). Table 2 is mainly descriptive and cross-sectional analyses are more informative as to the factors associated with the risk shifts of foreign listed firms. Given that the more fundamental effects of the legislation appear to have occurred over the longer-term period reported, we concentrate the cross-sectional analyses on these longer-term risk shifts. 4. Cross-sectional analyses With its focus on calming investor fears, the Sarbanes-Oxley legislation emphasizes enhancements in governance and disclosures for all firms listed on U.S. exchanges. The premise is that firms with strong governance and disclosure are associated with less uncertainty. We identify several variables that reflect the degree of uncertainty, and evaluate whether the degree of uncertainty can explain the cross-sectional variation in the risk shifts of our sample of foreign firms. The hypothesis that we seek to assess is whether foreign firms with greater uncertainty in the pre-SOX period experienced greater declines in their capital market risk measures. We may find those firms considered to be more uncertain in the pre-SOX period to have greater risk reductions, if the SOX provisions were effective in reducing investor uncertainty. Alternatively, it might be that firms considered to be less uncertain in the pre-SOX period were rewarded for their low degree of uncertainty. As increased scrutiny and concern with governance and disclosure intensified along with the passage of SOX, firms with less uncertainty in the pre-SOX period may have experienced risk reductions in the post-SOX period. It is challenging to gather cross-sectional variables when working with a sample of foreign firms from 47 different countries. Nevertheless, each of the nine variables described below reflects some facet of investor uncertainty. The variables are constructed using data from CRSP, Compustat, and S&P Governance databases. 4.1. Spread Microstructure theory identifies asymmetric-information costs, order-processing costs, and inventory holding costs as the three main sources of influence on bid-ask spreads. Essentially, higher bid-ask spreads reflect greater uncertainty associated with the underlying stock (i.e., Copeland and Galai (1983) and Welker (1995)). Copeland and Galai (1983) show that the bid-ask spread is a positive function of return variance of the underlying stock. Welker (1995) reports a negative association between disclosure levels and relative bid-ask spreads. Spread is the 36-month average in the pre-SOX period of (ask price − bid price)/((ask price + bid price)/2) using end of month price data from CRSP. 4.2. Trading volume There are studies that show stocks with high proportion of trading volume have greater uncertainty and also studies that show they have less uncertainty. While finance theory about the impact of uncertainty on trading volume is ambiguous, with some assumptions regarding liquidity trading two models have been developed. Assuming liquidity trading is exogenous and inelastic to price, Kyle (1985) provides a model in which there is a positive relation between trading volume and information asymmetry. In contrast, models developed by Admati and Pfleiderer (1988) show that trading volume can decrease when information asymmetry increases, if there is time discretion in liquidity traders. Trading volumes are measured as the total number of shares traded over the 36 months in the pre-SOX period divided by the total number of shares outstanding as of 30 April 2002 from CRSP. 4.3. Developing country In general, firms from developing countries are regarded as more uncertain. Developing Country is a dummy variable set equal to one if the firm is from the countries of Argentina, Bahamas, Bermuda, Brazil, British Virgin Islands, Cayman Islands, Chile, China, Hungary, India, Indonesia, Israel, Liberia,

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Marshall Islands, Mexico, Netherlands Antilles, Panama, Papua New Guinea, Peru, Philippines, Russia, Singapore, South Africa, South Korea, Taiwan, and Venezuela. 4.4. Tax Haven country Firms that are from tax haven countries are likely regarded as more uncertain, especially as the corporate wrongdoings were uncovered that led up to the passage of SOX. Tax Haven Country is a dummy variable set equal to one if the firm is from the tax haven countries of Bahamas, Bermuda, British Virgin Islands, Cayman Islands, Liberia, Marshall Islands, Netherland Antilles, and Panama. It can be noted that Tax Haven Country is a subset of Developing Country. 4.5. Governance score Firms with stronger governance should provide stronger oversight that protects shareholders, and may lead to greater certainty. Indeed, SOX emphasizes enhanced governance, presumably with the goals of protecting shareholders and calming investor fears. Nevertheless, it can be argued that better investor protection may induce managers to take less conservative investment strategies, leading to a greater degree of firm risk (e.g., John et al., 2005). Following Litvak (2007), we use the ratings developed by S&P for major public companies around the globe that were created in 2001 as Governance Score. Patel and Dallas (2002) describe this score as being composed of three sub-scores—financial transparency and information disclosure, board and management structure and process, and ownership structure and investor relations. These ratings are available for only 208 of our 417 sample firms. 4.6. Firm size Smaller firms are generally believed to be riskier with more uncertain outcomes. However, larger firms are more complex and as a result may be more uncertain, especially at the time when the financial statements of large firms, such as Enron and WorldCom, were often complex and misleading. Adding to the complexity of non-U.S. firms are business groupings, such as keiretsus, that are prevalent in foreign countries. Since large firms tend to be involved in these business groupings (e.g., Dewenter et al., 1999), large firms likely have greater complexity and opacity. Firm Size is defined as the natural log of market value of equity using 2001 calendar year-end data from Compustat. 4.7. Financial leverage A firm with greater leverage is considered to be riskier. Baxter (1967) shows that, due to the potential bankruptcy costs, there may be a positive relationship between leverage and cost of capital. Datta et al. (1999) report that higher leverage ratio is associated with higher yield spread on initial public straight bond offers. Datta et al. (1999) attribute this result to the higher default risk with higher leverage. Financial leverage is defined as the ratio of total debt to total assets using 2001 calendar year-end data from Compustat. 4.8. Operating return Operating return on assets is a measure of firm performance. It is plausible that stronger performing firms are considered to be less uncertain. Operating Return is defined as the ratio of earnings before interest, taxes, depreciation and amortization to total assets using 2001 calendar year-end data from Compustat. 4.9. Market-to-book Higher market-to-book ratios might reflect uncertainty since they capture greater expected growth and/or greater degree of mispricing. Relating a firm’s future growth options to its market-to-book ratio, Myers (1977) develops a model where a firm whose value depends largely on the future growth

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Table 3 Descriptive statistics for the cross-sectional variables. Variable

Mean

Median

Spread Trading volume Developing country Tax Haven Country Governance score Firm size Financial leverage Operating return Market-to-book

1.9082 5.1835 0.7386 0.1295 54.8995 6.6517 0.5187 0.0698 2.4794

0.2471 3.0600 1.0000 0.0000 56.2293 6.6853 0.5336 0.0967 1.6562

This table presents the descriptive statistics of our proxies for the degree of uncertainty inherent in the sample firm. Spread is the 36-month average in the pre-SOX period of (ask price − bid price)/((ask price + bid price)/2). Trading volumes are measured as the total number of shares traded over the 36 months in the pre-SOX period divided by the total number of shares outstanding. Developing country is a dummy variable set equal to one if the firm is from the countries of Argentina, Bahamas, Bermuda, Brazil, British Virgin Islands, Cayman Islands, Chile, China, Hungary, India, Indonesia, Israel, Liberia, Marshall Islands, Mexico, Netherlands Antilles, Panama, Papua New Guinea, Peru, Philippines, Russia, Singapore, South Africa, South Korea, Taiwan, and Venezuela. Tax Haven Country is a dummy variable set equal to one if the firm is from the tax haven countries of Bahamas, Bermuda, British Virgin Islands, Cayman Islands, Liberia, Marshall Islands, Netherland Antilles, and Panama. Following Litvak (2004), we use the ratings developed by S&P as Governance score. Firm size is defined as the natural log of the market value of equity. Financial leverage is the ratio of long-term debt to total assets. Operating return is the ratio of earnings before interest, taxes, depreciation and amortization to total assets. Market-to-book is measured as equity market value divided by equity book value. The statistics below are based on a sample size of 417, except Governance score is based on a sample size of 208.

tends to use less debt financing as it is possible that these managers could make investments that are particularly detrimental to bondholders. Gompers (1995) reports an increase in expected agency costs with increased growth options in the firm. It is measured as the equity market value divided equity book value using 2001 calendar year-end data from Compustat. Table 3 reports the means and medians of each of these variables. The mean spread is 1.9082, while the median spread is 0.2471. The mean (median) 3-year trading volume as a percentage of shares outstanding is 5.18 (3.06). The proportion of firms from developing countries is 73.86%, and the proportion of firms from tax haven countries is 12.95%. The mean (median) governance score is approximately 55 (56). The mean and median firm size, measured as the natural log of market value of equity, is 7.0 and 7.8, respectively. Financial leverage of the average firm in our sample is 51.87% and for the median firm it is 53.36%. Operating return on assets is 6.98% on average, and 9.67% at the median. The mean (median) market-to-book ratio is about 2.48 (1.66). The regression analyses evaluate whether these nine variables help explain the cross-sectional variation in the risk shifts. We concentrate on examining the variation in the longer-term risk shifts, since the fundamental effects of the legislation appear to have occurred over this period of time, based on the reductions in total and unsystematic risk shifts documented in Panel B of Table 2. Table 4 reports the results of the ordinary least squares regressions, using each of the three risk shifts measured over the longer-term period as dependent variables. Two different models are estimated, where Model 1 excludes Governance Score because its inclusion substantially reduces the sample size and Model 2 includes Governance Score but excludes Developing Country and Tax Haven Country.8 Regression coefficients are reported along with White-adjusted t-statistics in parentheses. The coefficients on Spread are positive and significant for all three risk shift measures and for both models, except for Model 2 with the unsystematic risk shift. This finding indicates that more (less) uncertain firms, i.e., those firms with larger (smaller) bid-ask spreads, are associated with smaller (larger) decreases in risk. Trading Volume is found to be negatively associated with the risk shifts, but it is significant only with Model 1. To the extent that heavy trading volume is associating with less

8 Model 2 necessarily omits Tax Haven because with this reduced sample there is no variation in this measure. Additionally, we remove Developing Country from Model 2 because its correlation with Governance Score appears to interfere with the significance of Governance Score. When we include Developing Country in Model 2 it is not found to significantly explain any of the risk shift measures.

Variables

Total risk Model 1

Intercept Spread Trading volume Developing country Tax Haven Country Governance score Firm size Financial leverage Operating return Market-to-book

−4.0842 (−4.89)*** 0.1961 (2.52)*** −6.9584 (−2.17)** −0.0750 (−0.21) 0.0665 (0.11) – 0.3478 (3.03)*** 0.8139 (0.86) 0.1575 (0.08) −0.0636 (−1.50)

N Adj. R2 F

417 0.0688 4.84***

Unsystematic risk Model 2 −2.8821 (−2.74)*** 0.0902 (2.28)** −2.8515 (−0.95) – – −0.0223 (−1.71)* 0.3369 (1.99)** 1.3096 (1.64) −1.5462 (−0.51) −0.0116 (−0.47) 208 0.0718 3.29***

Model 1 −2.3703 (−3.29)*** 0.1521 (1.90)* −4.2347 (−2.00)** −0.1118 (−0.36) −0.4820 (−0.83) – 0.2097 (2.01)** 0.0846 (0.10) 0.0450 (0.03) −0.0426 (−1.58) 417 0.0400 3.17***

Market risk Model 2 −1.1811 (−1.57) 0.0396 (1.39) −2.4286 (−1.00) – – −0.0176 (−1.72)* 0.1865 (1.39) 0.5190 (0.89) −1.8030 (−0.77) −0.0112 (−0.61) 208 0.0286 1.87*

Model 1 −0.8055 (−4.08)*** 0.0250 (3.18)*** −0.9673 (−1.81)* 0.1274 (1.20) 0.3635 (2.68)*** – 0.0878 (4.47)*** 0.4872 (2.48)*** −0.0899 (−0.30) −0.0115 (−1.11) 417 0.1035 7.01***

Model 2 −0.8746 (−3.09)*** 0.0209 (1.83)* −0.4438 (−0.69) – – 0.0039 (1.15) 0.0581 (1.43) 0.7218 (2.89)*** −0.0538 (−0.09) 0.0037 (0.62) 208 0.0919 3.99***

Below are the regression results estimated for models that differ with respect to the risk shifts used as the dependent variable. All independent variables are same as those in Table 3. Regression coefficients are reported along with White-adjusted t-statistics in parentheses. *** , ** , and * indicate significance at the 1%, 5%, and 10% levels, respectively.

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Table 4 Results of cross-sectional regressions on foreign firm risk shifts.

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uncertainty, this finding can also be interpreted as showing firms with more uncertainty experienced smaller decreases in risk. While we do not find Developing Country to be significant, Tax Haven Country is significantly related to the change in market risk in Model 1.9 Firms from countries considered to be more uncertain, experienced greater increases in market risk. The coefficient on Governance Score is negative and marginally significantly associated with the changes in total risk and unsystematic risk in Model 2. This provides some evidence that firms with better governance, and are arguably less uncertain, experienced greater decreases in risk. The coefficient on Firm Size is positive and significant in Model 1 for all three risk shift measures and in Model 2 for the total risk shift. If larger firms are more complex and uncertain, this finding again shows that the more uncertain foreign firms are associated with smaller decreases in risk. Lastly, the results show Financial Leverage to significantly influence the cross-sectional variation in the market risk shifts. The positive coefficient indicates that those firms with more leverage experienced greater increases in market risk. The overall conclusion that we can draw from the results in Table 4 is foreign firms that are considered to be less uncertain are associated with larger decreases in capital market measures of risk. Instead of finding that firms considered to be more uncertain in the pre-SOX period to be associated with risk reductions, we find that these more uncertain firms experienced smaller risk reductions than firms with less uncertainty. Indeed, foreign firms with less uncertainty received incremental benefits in the post-SOX period of reduced levels of risk. Thus, an important implication for foreign issuers, given the controversy surrounding the applicability of SOX to foreign issuers, is that those considered to be less uncertain in the pre-SOX period were rewarded in the post-SOX period for their low degree of uncertainty. Our results are similar to those of Akhigbe and Martin (2008) who show that larger (smaller) risk increases of financial services firms in a post-SOX period occur for those with poorer (better) disclosure and governance, where firms with poorer (better) disclosure and governance are likely considered to be more (less) uncertain. 5. Summary All foreign firms listed on U.S. exchanges are required to comply with the Sarbanes-Oxley Act of 2002 passed by U.S. legislators. Our main objective is to assess whether the foreign issuers experienced changes in risk following the passage of SOX. We examine whether capital market risk measures changed in the post-SOX period for a sample of 417 foreign firms listed in the U.S. representing 47 countries. We find an element of good news in the post-SOX period for foreign firms listed in the U.S. The good news is that capital market measures of total risk and unsystematic risk, on average, decreased over a 3-year period following the passage of SOX. Though, the changes in risk are found to depend on the length of the horizon over which the risk shift is estimated. Our cross-sectional analyses show foreign firms that had less uncertainty at the time of SOX passage benefited to a greater extent, as they experienced the greatest risk reductions in the post-SOX period. It appears the heightened awareness and investor focus that occurred in conjunction with the passage of SOX translated into lower capital market risk measures for those foreign firms with less uncertainty. That is, they were rewarded for their low uncertainty. Acknowledgments The authors would like to thank an anonymous reviewer, as well as gratefully acknowledge financial support from the Moyer endowment at the University of Akron and the Theis endowment at St. John’s University.

9 We also adjust the definition of this developing country dummy variable to categorize South Africa, South Korea and Singapore as developed countries, and find the same results.

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