Thursday, June 28, 2007

SOX, IPOs and Corporate Risk Taking: Part 2 of 3

Though the study asks 3 very timely and important questions, the consensus of the reviewers appears to be that the methodology they used in arriving at their conclusions lacks rigor.
Notably, some of the criticisms were:

1) In order to answer the first question regarding corporate risk-taking (R&D expenditures etc.) the study should be extremely careful to control for the commonly known determinants of corporate risk-taking. Of which there are many - notably leverage (which has been widely discussed in prior literature) and other firm-specific and industry-specific characteristics..and size. (Pretty much ANY study in ANY area of finance should control for size, as we are taught in grad school).
In short, there may be other differences between the US and UK firms that may account for their level of risk-taking and these (as a non-scientist, am I permitted to say 'Occam's Razor' here?) should first be considered and eliminated before attributing the difference to SOX.

2) Dr. Kate Litvak in her discussion of point 2 regarding the number of IPOs listed in the UK and US, points out this paper: "Has New York become less competitive in global markets? Evaluating foreign listing choices."
They summarize their findings:
"We find that cross-listings have been falling on U.S. exchanges as well as on the Main Market in London. This decline in cross-listings is explained by changes in firm characteristics rather than by changes in the benefits of cross-listings. We show that, after controlling for firm characteristics, there is no deficit in cross-listing counts on U.S. exchanges related to SOX. Investigating the cross-listing premium from 1990 to 2005, we find that there is a significant premium for U.S. exchange listings every year, that the premium has not fallen significantly in recent years, that it persists even when allowing for unobservable firm characteristics, and that there is a permanent premium in event time....Our evidence is consistent with the theory that an exchange listing in New York has unique governance benefits for foreign firms. These benefits have not been seriously eroded by SOX and cannot be replicated through a London listing. "

Why do their conclusions differ so dramatically from those of the AEI paper? I cannot be sure without some analysis, but Dr. Litvak does so and provides a big clue: If we control for firm characteristics, then there is no change in the number of US listings.

One other point is the country of origin effect. It may be hypothesized that a UK company is more likely to IPO in the UK than the US, other things remaining equal. However it appears that the authors do not provide for this country of origin preference.

3) The third conclusion was regarding the risk of US and UK equity. Without challenging the finding itself, I cannot conclude that this is a bad thing. The US stock market, as the most developed market in the world, may well be the lease volatile. Further it may be becoming less and less volatile i.e. gaining in strength. Even if SOX did make the market less risky, where do we draw the line between 'less risky' and 'so less risky it may be unhealthy'?

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