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Johnson Finance Professor’s Research Guides SEC in Important Report to Congress

05/08/2012

The securities regulatory agency heavily cited Andrew Karolyi’s research on barriers to U.S. investment in emerging markets


On April 11, 2012, The U.S. Securities and Exchange Commission (SEC) released a detailed report on the economic impact of the U.S. Supreme Court’s 2010 ruling in Morrison v. National Australia Bank, largely utilizing empirical research conducted by Andrew Karolyi, Faculty Co-Director of Emerging Markets Institute, Alumni Professor in Asset Management, and professor of finance at the Samuel Curtis Johnson Graduate School of Management at Cornell University. Revisiting the 2010 Supreme Court ruling is among the requirements mandated by the Dodd–Frank Wall Street Reform and Consumer Protection Act, signed into law in July 2010. 

The SEC used a 2011 study co-authored by Karolyi and Louis Gagnon of Queen’s University’s School of Business to re-examine the Morrison decision, one that has caused much confusion in protections available to those investing in foreign-based companies. In the Morrison case, the Supreme Court ruled that protections against fraud provided to those investing in U.S. interests do not apply to investors who purchase securities listed on non-U.S. stock exchanges. These protections do not apply regardless of the extent or type of the fraud conducted or the effects of such conduct in the U.S. or on U.S. citizens.

Before the Supreme Court’s Morrison decision in June 2010, investors had fraud protection in U.S. courts, regardless of the country in which they purchased stock, said Karolyi.
 
“It shouldn’t matter where you purchase [stock] shares,” Karolyi said. “Shares traded in the U.S. and in the home markets for these foreign companies should be fully fungible, but the Supreme Court decision has made us think about these as two very different things.”

The Morrison decision has created barriers and caused confusion on where and how investors can seek protection from fraud, and it has discouraged U.S. investment abroad by major institutional investors, exposing them to more risk and less protection. For example, if a transaction occurs on a foreign stock exchange, a foreign broker may not be liable for fraud, even if the investor lived in the U.S. or the broker came to the U.S. to meet with the shareholder. One result is that many investors pass up on investment opportunities in emerging markets.

For more than 15 years, Karolyi has studied the causes, consequences, benefits and challenges of companies cross-listing their stock on multiple, international exchanges. He studied the activity of foreign companies listing on U.S. stock exchanges during the last 20 years and found that in the 1990s, thousands of firms cross-listed secondarily on U.S. exchanges, because they sought investors, but also gained global credibility by complying with stringent American regulations enforced by the SEC.

His study with Gagnon, which was one of three that were cited by the SEC report, proved that the Morrison decision had negative economic consequences for the markets and for the foreign companies that secondarily cross-list their stocks on U.S. exchanges.
 
“We studied what happened to the price differences between the U.S. listed and home-market shares around the Court’s decision,” Karolyi said. “We were uniquely positioned to do this, because we have conducted extensive research on [share] price gaps.

Karolyi and Gagnon found that if people value legal protections when purchasing stock (and most do), and if legislation makes a distinction on where investors purchase stock, because of the fraud protection they may or may not receive, the stock price difference from country-to-country widens systematically.

“We showed that the Court’s decision created negative consequences, because it led to a wedge [in stock prices] for no good reason,” Karolyi said. “It created significant dislocation in the marketplace.”
 
In principle, stock price gaps between U.S. listed and home market shares are small. But Karolyi said the Supreme Court’s decision artificially spurred a widening of the stock price gaps. Overall, Karolyi argues, this dislocation may stifle further U.S. investment in emerging markets by causing fewer companies to secondarily cross-list on U.S. Exchanges in the future.

With the SEC’s report submitted to Congress, political dialogue will ensue and Congressional hearings will now follow. Over time, depending on the results of the hearings, Karolyi said there also may be some refinements made to lessen the negative economic impact of the Morrison decision.

You can view the full SEC report, in which Karolyi’s research is cited, here. Several national media outlets have also featured discussion on the report and its findings, including Reuters and The New York Times.--Pamela Woodford

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