Effective Legal Bonding Reduces Adverse Selection: Evidence from a Positive Shock to Monitoring and Enforcement

• In Event: CSR and Enforcement

Abstract

Prior research posits that firms from less developed countries reduce adverse selection concerns by bonding themselves to exchanges in more developed countries. The bonding hypothesis conceptually identifies legal and reputational channels. There is debate surrounding the effectiveness of the two channels which are often conflated. This paper empirically isolates the legal channel by examining a positive shock to public enforcement and legal bonding—the 2013 Sino-U.S. agreement on enforcement cooperation—which resolved a three-year credibility crisis for U.S.-listed Chinese firms. I hypothesize and provide two sets of evidence that the agreement yields effective legal bonding and reduces adverse selection. First, high- and low-value U.S.-listed Chinese firms’ valuations become significantly more dispersed post-cooperation. Second, the average information asymmetry component of the bid-ask spread, book-to-market ratio, and zero return days fall while share turnover rises post-cooperation. While reputation-building practices were not effective at reducing adverse selection pre-cooperation, the agreement has higher impact on firms with existing better reputation. The combined results suggest complementarity between legal bonding and reputational bonding.

Author

• Disen Huang, New York University