The Home Stigma: Adverse Selection in ADRs and the Home Capital Market Environment

Abstract

We investigate whether characteristics of the home country capital market environment, such as information disclosure and investor rights protection, continue to affect ADRs cross-listed in the U.S. Using microstructure measures as proxies for adverse selection, we find that characteristics of the home markets continue to be relevant, especially for emerging market firms. Less transparent disclosure, poorer protection of investor rights, and weaker legal institutions are associated with higher levels of information asymmetry. Developed market firms appear to be affected by whether or not home business laws are of common law or civil law legal origin. To further understand the persistence of the home capital market effect, we find that regulatory effectiveness is an important determinant. The home capital market environment effect becomes weaker for emerging market firms after the enactment of the Sarbanes-Oxley Act. The bid-ask spread, as a measure of adverse-selection cost, increases two years into a cross-listing, and stays high for emerging market ADRs. Our finding contributes to the bonding literature. It suggests that cross-listing in the U.S. should not be viewed as a complete substitute for improvement in the quality of local institutions, and attention must be paid to improve investor protection in order to achieve the full benefit of improved disclosure. Improvement in the domestic capital market environment can attract more investors even for U.S. cross-listed firms. It also suggests that regulatory tightening in the U.S. has a bigger effect on emerging market ADRs than developed market ADRs.