country and the home country.

While the cross-listing literature assesses the benefits of listing in a stronger legal and

regulatory environment, this paper seeks supporting evidence of the opposite direction, that is,

when a firm chooses a less demanding environment that can benefit managers and insiders at

the expense of ordinary shareholders. In particular, we evaluate firms that select an alternative

legal and regulatory system by incorporating in an offshore financial center (OFC).

Jurisdictions ranging from city-states to tiny island dependencies structure their legal and

regulatory regimes to encourage many financial activities including incorporation of foreign

firms (Lane and Milesi-Ferretti, 2010). Places like Bermuda, the British Virgin Islands, and the

Cayman Islands compete with larger capital markets and can offer low-cost, efficient legal

conditions that can enhance firm value and pressure other jurisdictions to improve (Morriss,

2010). At the same time, ofCs have been accused of enabling mis-management and

expropriation by self-serving corporate managers or controlling owners, in addition to tax

evasion, accounting opacity and other questionable or illegal behavior (Mendis, Suss, Williams,

and Mendis, 2002; Zoromé, 2007).4

4

See “At Orient Express, the Board holds All the Cards”, New York Times Dealbook, 29th November 2012,

(http://dealbook.nytimes.com/2012/11/29/at-orient-express-the-board-holds-all-the-cards/) for an example of

how managers can control a firm and their own employment conditions under Bermuda law.

2

We study the value, governance, and other characteristics of firms incorporated in OFCs

relative to other firms, the effect of a firm moving its incorporation to or from an OFC, and the

performance of initial public offerings of firms incorporated in foreign OFCs. We seek to

understand whether incorporation in an OFC improves or detracts from corporate value and

quality. In doing so, we shed light on the motivations of these firms and the jurisdictions that

compete to attract them. We focus on OFCs because they offer corporations an extreme form of

jurisdiction-shopping that has become increasingly controversial.

The results presented in this draft of the paper indicate that incorporation in an OFC is

associated with lower stock market value as measured by Tobin’s q and poorer corporate

governance as measured by the fraction of insider ownership. This is consistent with OFC

Incorporation furthering the ability of managers and insiders to exploit other shareholders,

rather than enhancing value with an efficient, low cost legal environment that offers advantages

over incorporation in the US, UK, or other large capital markets. The evidence reminds us that

a variety of outcomes from competition and innovation in financial market institutions is

possible. In future revisions, we will extend our examination of OFC incorporation and firm

characteristics to capital expenditure, use of global capital markets to raise money, productivity

as measured with patents, and managerial characteristics.

2. Offshore Financial Centers

3

specializing in providing financial services to non-residents? Zoromé (2007) cites several more

specific definitions from IMF publications of the last decade or two. For example:

“…’the banking system, acting as financial entrepôt, acquires substantial external

accounts beyond those associated with economic activity in the country concerned,’ or

countries where the ratio of deposit banks’ external assets to exports of goods and

services is significantly higher than the world average.”

“…a jurisdiction in which its international investment position assets, including as

resident all entities that have legal domicile in that jurisdiction, are close to or more

than 50 percent of GDP and in absolute terms more than $1 billion.”

The scale of activity in OFCs is difficult to measure as statistics are often sparse, but the

amount of financial activity in these places seems large. In Bermuda in 2003, for example

(Zoromé, 2007; Table 8), net export of financial services was 42% of GDP and portfolio assets

were over 100 times GDP. Jurisdictions with the 2003 ratio of net export of financial services to

GDP more than two standard deviations above the mean include Bahrain, Barbados, Bermuda,

Cayman Islands, Guernsey, Hong Kong, Isle of Man, Jersey, Latvia, Luxembourg, Mauritius,

4

hold about one-eighth of global bank assets. OFC activities can contribute significantly to

government revenue and employment in a small economy,5 diversifying away from traditional

sectors such as agriculture and tourism.

In addition to regulatory differences, the activity in OFCs is also related to corporation

and personal taxation. As such, these jurisdictions are often referred to as “tax havens”. Hines

and Rice (1994) study the use of tax haven affiliates by US corporations. They find that these

affiliates account for about 20% of all US foreign direct investment, and suggest that they are

motivated by low tax rates. Desai, Foley, and Hines (2006) detail the characteristics of US

multinationals that use OFCs and the nature of the tax advantages they gain. Dyreng and

Lindsey (2009) measure a significant tax saving for US firms who use at least one OFC. These

papers demonstrate how OFCs can generate value for foreign corporations by reducing taxes.

In addition to tax benefits, Morriss (2010) notes that OFCs help US corporations lower the

cost of insurance and employee healthcare.6 At the same time, he mentions prominent events

in which OFCs are associated with local government corruption, the narcotics trade, financial

fraud, and tax evasion. OFCs certainly offer substantially different conditions to foreign

5

In 2001 for the British Virgin Islands, for example, Suss, Williams, and Mendis (2002) report there were over

300,000 “international business corporations”, and 15% of all local employment and 55% of government

revenue related to OFC functions.

6

An extreme example is hedge funds setting up offshore reinsurance units that invest back into the hedge fund.

See “With Lax Regulation, a Risky Industry Flourishes Offshore, in New York Times Dealbook, 5th September

2012, (http://dealbook.nytimes.com/2012/09/04/with-lax-regulation-a-risky-industry-flourishes-offshore/).

5

Virgin Islands features no disclosure requirements, minimal numbers of directors and

shareholders, management anonymity, and ease of transfer of corporate assets, in addition to

tax exemptions.7 Whether OFCs facilitate healthy competition between jurisdictions or a “race

to the bottom” continues to be debated.8 In the model of Bar-Gill, Barzuza, and Bebchuk

(2006), reincorporation improves the welfare of shareholders on some dimensions (such as

Delaware’s court system or an OFC’s tax system) at the cost of freeing insiders to expropriate

more wealth. Competition from other jurisdictions limits the revenue that an OFC can extract

from firms.9 Thus, the costs and benefits associated with a firm’s choice of jurisdiction for

7

See http://www.bviifc.gov.vg/FinancialSectors/CorporateBusiness/Advantages/tabid/157/Default.aspx. For a

discussion of the potential tax, governance, and regulatory advantages of Michael Kors Holdings incorporating

in the British Virgin Islands while being headquartered in Hong Kong see “The Benefits of Incorporating

Abroad in an Age of Globalization”, New York Times Dealbook, 20th December 2011,

(http://dealbook.nytimes.com/2011/12/20/the-benefits-of-incorporating-abroad-in-an-age-of-globalization/) .

8

For example, Hong Kong’s Jardine group of companies reorganized under a Bermuda-domiciled holding

company in 1984. Aspects of Bermuda law were thought to enhance the Keswick family’s control of the group,

which could protect the company once control of Hong Kong returned to China in 1997 or could increase the

power of insiders relative to minority shareholders.

9

For example, the maximum annual corporate franchise fee is about $30,000 in Bermuda and only a few

thousand dollars per year in the British Virgin Islands or the Cayman Islands (www.taxrates.cc). For comparison,

Delaware’s maximum annual fee is $180,000 (corp.delaware.gov/frtaxcalc.shtml). Public information on the

specific legal expenses of incorporation or re-incorporation of a substantial listed public company does not seem

available See, for example, http://www.calstrs.com/Newsroom/whats_new/cominghomeISS.aspx concerning

Tyco International. Tyco’s Form S-4 dated 10th December 2008 states (page 23) “…we do not expect these costs

to be material…” Consent of the shareholders and directors must be obtained. According to law firm websites, a

straightforward incorporation of a small firm would cost several thousand dollars in legal fees. See “The

incorporation business: They sell sea shells”, The Economist, 7th April 2012,

http://www.economist.com/node/21552197/print.

6

incorporation are complex. Our evidence clarifies the net effect of OFC incorporation by

relating it to firm value.

An anecdote illustrates the ambiguous potential impact of re-incorporation in an OFC.

Tyco International, a US listed corporation, moved its legal domicile from Bermuda to

Switzerland in 2009. The company’s 2009 10-K annual report states that the change in

incorporation will enhance “our ability as a Swiss company to take advantage of the tax

treaties between Switzerland and the United States”. On the same page, “there continues to be

negative publicity regarding, and criticism of, companies that conduct substantial business in

the U.S. but are domiciled abroad”. The document goes on to say “Because of differences

between Swiss law and Bermuda law and differences between the governing documents of

Swiss and Bermuda companies, it may not be possible to enforce court judgments obtained in

the United States…in Switzerland”. Thus, incorporation in an OFC can convey benefits such

as tax advantages or can harm shareholders by reducing their ability to control management

or damaging the company’s reputation.

The OECD’s Financial Action Task Force in 2000 and 2001 declared a number of OFCs to

be “non-cooperative” for issues such as money laundering, weak law or regulation, obstructing

international law enforcement, and inadequate allocation of resources to law and regulation.

International organizations have continued to monitor, offer assistance, and apply pressure to

OFCs to upgrade the quality of their legal, regulatory, and disclosure environments

7

uses and abuses of OFCs given involvement in recent scandals (van der Does de Willebois,

Halter, Harrison, Park, and Sharman, 2011; Shaxson, 2011) and continued easy creation of

shell companies and other offshore entities. While there is almost no academic research on

OFCs, what little exists suggests that OFCs are associated with poorer-quality firms (Durnev,

Li, and Magnan, 2011). Evidence on announcement effects and other dimensions of valuation

surrounding the incorporation event in OFCs is mixed.10 Adding to the controversy, some

OFCs were heavily involved in the US securitization boom which fed the recent financial crisis

(Lane and Milesi-Ferretti, 2010).

A recent development is the increase in problems associated with OFC-incorporated

Chinese companies listed in US and other non-Chinese stock markets. The growth in China’s

economy has outpaced legal, regulatory, and disclosure practices. Therefore, OFCs may

provide Chinese firms with a more secure and predictable legal system. Recently, however,

several Chinese corporations that listed in the US have suffered from management problems

and scandals (see, for example, Hung, Wong, and Zhang, 2011). Regulators explicitly

mention the entry of problematic Chinese companies to US stock markets using reverse

mergers (Public Company Accounting Oversight Board, 2011; United States Securities and

10

Desai and Hines (2002) find an average announcement response of 1.7% for 19 US firms moving

incorporation to an OFC from 1993 to 2002. Durnev, Li, and Magnan (2012) find that small positive

announcement effects for registering or establishing a subsidiary in an OFC vanish after 2002 while valuation is

lower except for UK and US firms establishing OFC subsidiaries.

8

Chinese firms to list a holding company in the U.S. appear to violate Chinese law.11 The

variety of problems surrounding Chinese companies has attracted both law enforcement and

aggressive stock traders from beyond mainland China.12 Ang, Jiang, and Wu (2012) explore

the characteristics of US listed Chinese firms that have been involved in scandals. They find

that listing by reverse merger, greater earnings management, and weaker corporate

governance predict greater likelihood of scandal. Many of the recent US listings from China

are incorporated in offshore financial centers, particularly the Cayman Islands.13 From a

broader perspective, this paper studies the contribution of OFC incorporation to the frequency

and cost of these scandals.

3. Empirical design

3.1 Testable hypotheses

11

See “China’s Forbidden Investment, 1st March 2012,

See

http://www.rkmc.com/publications/articles/china-s-forbidden-investment.

12

http://dealbook.nytimes.com/2012/01/27/f-b-i-searches-offices-of-n-y-adviser-on-chinese-reverse-mergers

http://www.reuters.com/article/2011/06/06/businesspro-us-china-stocks-muddywaters-idUSTRE7556D0201106

06 .

13

See Darrough,, Huang, and Zhao (2012), Jindra, Voetmann, and Walkling (2012), and Givoly, Hayn, and

Lourie (2012) for further evidence on Chinese firms listed in the US and, in particular, on the associations

between reverse listing and firm quality.

9

firm chooses to list on a US stock market. In deciding whether to list shares in the US, a non US

firm’s controlling shareholders face a trade-off. The firm can grow faster by raising additional

capital under the extensive investor protection of the US legal and regulatory system, though

this constrains the ability of controlling shareholders to expropriate minority shareholders. If

cross-listing in the US imposes higher legal and regulatory standards on a non US firm, the

firm increasing its value by cross-listing in the US.

Similarly, we can imagine that incorporation in an offshore financial center can move a

firm in the other direction, that is, to a less-demanding environment, but at the same time offer

potential expropriation benefits to insiders and tax benefits to all shareholders. Therefore, we

adapt the setting, notation, and solution of Doidge, Karolyi, and Stulz (2004) to the case where

investor protection afforded by incorporation at home, ρhome, is greater than the investor

protection when incorporated in an offshore financial center, ρofc. Controlling shareholders are

entitled to a fraction, k, of the cash flow, C, of the firm and select the fraction, f, of firm cash

flow that they expropriate beyond kC.14 Expropriation imposes a cost which is quadratic in the

fraction expropriated and linearly increasing in the quality of investor protection, ρ, in the

jurisdiction where the firm chooses to incorporate. Furthermore, if the firm is incorporated not

14

C is assumed to be exogenous but we can imagine a more complex model in which managerial decisions

such affect the distribution and value of C and are enabled or discouraged by the legal and regulatory system the

firm chooses.

10

at home but in an OFC, it loses the opportunity to finance growth opportunities worth z but

gains tax benefits worth τ.

Thus, controlling shareholders enjoy the following gain if incorporated at home:

k[(C+z) – f (C+z) – ½ b f2 ρhome(C+z)] + f(C+z)

(1)

where b is a constant greater than zero. In (1), the term in brackets is the cash flow of the firm

minus expropriation and minus its deadweight cost. The term, f(C+z), on the right is the benefit

from expropriation enjoyed by controlling shareholders. The gain to controlling shareholders if

incorporated in an offshore financial center is:

k[(C+ τ) – f (C+ τ) – ½ b f2 ρofc(C+ τ)] + f(C+ τ)

(2)

Solve the maximization problem over f in both home and OFC incorporated situations and

substitute the solution into the original expressions to yield the total gain of the controlling

shareholders if incorporated at home:

k(C+z) + ½ [(1-k)2/bρhomek](C+z)

and their total gain if incorporated in an OFC:

k(C+ τ) + ½ [(1-k)2/bρofck](C+ τ)

(4)

(3)

Controlling shareholders will choose to incorporate in an OFC if their gain, (4) exceeds that for

incorporation at home, (3). Let ϴ equal the parameter ½ (1-k)2/bk:

k(C+z) + (ϴ /ρhome)(C+z) < k(C+ τ ) + (ϴ/ρofc)(C+τ)

(5a)

11

right-hand side is the payoff from greater expropriation by incorporation in an OFC.

Rearranging yields:

k(τ -z) + ϴ[((C+τ) /ρofc) – ((C+z) /ρhome)] > 0

(5b)

The comparative statics in Doidge, Karolyi, and Stulz (2004) imply, first, that growth

opportunities dissuade firms from incorporating in an OFC, and, second, that expropriation

opportunities encourage firms to incorporate in an OFC. This is confirmed formally in (5b).

Controlling insiders will select incorporation in an OFC if growth opportunities, z, are low

relative to tax savings, τ, and expropriation is much easier in an OFC (that is, 1/ρhome versus

1/ρofc).

We can also see how value differs from the point-of-view of minority outside shareholders

who do not enjoy any of the expropriation benefits of control. The firm’s cash flow to

controlling shareholders if incorporated at home, after they-have optimized f, is:

(C+z)(1 – [(ϴ/ρhome)(1+k)/(k(1-k)]

(6a)

The firm’s cash flow if incorporated in an OFC and controlling shareholders have

optimized f is:

(C+ τ)[1 – (ϴ/ρofc)(1+k)/(k(1-k))]

(6b)

12

a discount relative to firms incorporated at home, and that discount is increasing in growth

opportunities and the distance between ρhome and ρofc. In our case, the premium for

incorporating at home, (6a) minus (6b), is slightly more complicated because there is a

potential benefit, tax savings, to OFC incorporation in our model. Subtracting (6b) from (6a)

and simplifying yields:

(z–τ) – (C+z)[(ϴ/ρhome)(1+k)/(k(1-k)] + (C+τ)[(ϴ/ρofc)(1+k)/(k(1-k))]

(7)

In (7), the first term illustrates the trade-off between the value of growth enabled by

incorporation at home versus the value of tax shields enjoyed if incorporated in an OFC. The

second term enters (7) with a negative sign, indicating that the premium for incorporation at

home increases with investor protection: with larger ρhome the term vanishes. The third term

enters (7) with a positive sign, indicating that the premium for incorporation at home

increases with lower investor protection in the OFC: with lower ρofc the term grows and the

home premium becomes more positive. Finally, recall the composition of the parameter ϴ,

which equals ½ (1-k)2/bk and is therefore always positive. The fraction, k, of cash flow rights

held by insiders is exogenous in this model. When k equals one, ϴ is zero and (3) and (4)

show that there is no gain to expropriation because insiders are stealing dollar-for-dollar from

themselves, and at a cost.

13