Does One Size Fit All? The Consequences of Switching Markets with Different Regulatory Standards

• Published date: 01 November 2013
• Author: Tim Jenkinson,Tarun Ramadorai
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12021.x
• Date: 01 November 2013

Does One Size Fit All? The

Consequences of Switching Markets

with Different Regulatory Standards

Tim Jenkinson and Tarun Ramadorai

Said Business School, University of Oxford, Oxford‐Man Institute and CEPR

E-mails: tim.jenkinson@sbs.ox.ac.uk; tarun.ramadorai@sbs.ox.ac.uk

Abstract

As the regulation of public companies has tightened, many companies have

switched to stock exchanges with lower regulatory requirements. We analyse the

consequences for smaller quoted companies of switching between the two London

markets, which differ in their regulatory regimes. Firms that switch to lighter

regulation experience, on average, negative announcement returns of approxi-

mately 5%. However there is a longer‐term upward drift in stock returns after the

switch. We relate these financial returns to improvements in operating performance

in the years following the switch, suggesting that for some companies, and their

investors, a lighter regulatory environment may be appropriate.

Keywords: stock markets, listing, regulation, switching

JEL classification: G14, G30

1. Introduction

It is often taken as axiomatic that investors prefer higher levels of regulation of public

companies, and in recent years, often following scandals or crises, many countries have

progressively increased the level of such regulation. The most notable example of this

tendency was the passing of the Sarbanes‐Oxley Act in the USA, but world‐wide, stock

exchanges have for many years been increasing and tightening their requirements of listed

We thank an anonymous referee for very helpful suggestions, Andrea Randone, Roland

Fejfar, Opal Jiang, and Vesa‐Heikki Soini for excellent research assistance, and seminar

participants at London Business School, Helsinki School of Economics, Tilburg University,

Schulich School of Business at York University, the CEPR Gerzensee meetings and the

American Finance Association conference for comments. The views expressed here are ours

and we alone bear responsibility for any mistakes and inaccuracies. Correspondence: Tim

Jenkinson and Tarun Ramadorai.

European Financial Management, Vol. 19, No. 5, 2013, 852–886

doi: 10.1111/j.1468-036X.2013.12021.x

© 2013 John Wiley & Sons Ltd

companies in diverse areas, including firms’compliance with codes of corporate

governance and the information that listed firms must include in their prospectuses.

At the same time, we see many companies attempting to avoid these regulatory

burdens. More highly regulated stock markets in both the USA and the UK have seen

reductions in the number of initial listings, while more lightly regulated markets have

been favoured, especially by smaller firms. There has been a collapse of international

listings in the USA following the introduction of Sarbanes‐Oxley, and some US

companies have chosen to float on non‐US exchanges. A particularly impressive

development was the enormous growth of the lightly‐regulated Alternative Investment

Market (AIM) segment in London, which attracted close to 1,000 new (relatively small)

companies during 2005‐2006. The success of AIM resulted in other stock exchanges

launching similar segments, such as the Alternext market launched by NYSE‐Euronext,

and First North, part of the NASDAQ‐OMX group of exchanges, which covers the Nordic

and Baltic regions. Most recently, the dearth of IPOs, and a perception that regulation was

stifling the funding opportunities for entrepreneurs and small businesses, has resulted in

the Jumpstart Our Business Startups Act in the USA. The intention of the JOBS Act is to

make it easier for small businesses to raise capital, in part by relieving qualifying

companies

1

from certain regulatory requirements (including some that were introduced by

the Sarbanes Oxley Act) for several years after they go public. At the same time, the JOBS

Act has facilitated new innovations such as crowd‐funding, and has removed restrictions

on marketing securities offerings to the general public; see Ritter (2012) for an interesting

analysis of attempts to re‐energise the IPO market in the USA.

As many major stock markets around the world have experienced striking reductions in

the number of IPOs, the success of London’s AIM success has attracted some negative

attention, prompting calls from the leaders of rival exchanges and regulatory authorities

for AIM to raise its regulatory requirements.

2

This leads us to the question we address in

this paper: what are the consequences for companies, and their investors, of switching

between markets with different regulatory standards?

Financial markets are largely defined by regulation and technology. Regulation

includes financial services regulation, company law, and the specific requirements

imposed by the markets themselves. Technology relates to the trading systems that allow

market participants to interact with each other and to establish prices at which to trade.

Comparisons between markets are generally difficult as both technology and regulation

differ significantly. However, in this paper we consider the impact of regulation in a very

direct way, by analysing the experience of companies that switched between markets that

differ primarily in their levels of regulation. An important caveat is that the focus in this

paper is on the consequences for those companies that chose to switch regulatory regimes,

rather than investigating the possible determinants of the switching decision itself.

1

So‐called ‘emerging growth companies’, although some of those to take advantage of these

provisions are neither emerging nor have high rates of growth.

2

See, for instance, the article in the Financial Times on 27 January 2007, ‘NYSE chief says

AIM must raise standards’. This reports the views of the (then) NYSE chief executive John

Thain that ‘London’s Alternative Investment Market lacks stringent corporate governance

requirements for listed companies and should keep raising its standards.’Furthermore, on 9

March 2007, again in the Financial Times, US SEC commissioner Roel Campos is quoted as

saying that AIM ‘…feels like a casino to me, and I believe investors will treat it as such’.

© 2013 John Wiley & Sons Ltd

Does One Size Fit All? 853

The two markets that we consider are both part of the London Stock Exchange (LSE).

The Main Market (MM) of the LSE comprises securities that have satisfied the

requirements of the UK Listing Authority (UKLA). In addition, these companies are

subject to further requirements by the LSE. However, the shares of a company can also be

traded on the AIM market of the LSE. Companies traded on AIM are not listed, i.e., they

do not need to satisfy UKLA’s requirements, and the LSE imposes less stringent

requirements on them.

3

As we explain more fully in the next section, the regulatory

environment on AIM involves a high degree of self‐regulation by the company’s

nominated advisor, which acts as the main quality control mechanism. Furthermore,

companies on AIM face fewer continuing obligations in terms of reporting and corporate

governance. While the regulatory environment for the two markets is clearly different, the

trading mechanisms used by AIM companies are identical to those used by companies on

the MM, and both markets are subject to the same UK legal system that protects the rights

of shareholders.

Many countries have second‐tier markets, but several features of the UK markets make

them particularly suitable for our purposes. First, both markets are well‐established and

have large numbers of companies trading on them: at the end of 2006, there were around

800 companies

4

on the MM, and just over 1,600 on AIM. Of prime importance for our

research, there has also been a significant flow of companies switching between the

markets. Perhaps surprisingly, the net flow of companies switching markets has been very

heavily towards AIM. Our sample focuses on companies that switched markets before the

end of 2006. We restrict the sample to this period since we need to observe their

share prices for one year after switching and want to avoid the impact of the financial

crisis. The sample comprises 218 companies that have switched ‘down’to AIM, and

56 companies that switched from AIM ‘up’to the Main Market.

Second, as noted above, the growth and popularity of AIM was impressive in the years

leading up to the financial crisis. Although still predominantly a market that attracts

smaller companies, over a quarter of AIM companies have market valuations above £50m

($75m). AIM has attracted a growing number of overseas companies onto its market:

nearly 400 foreign companies were quoted on AIM at the end of 2006. In contrast to the

500 new companies joining AIM per year during 2005 and 2006, the MM attracted, on

average, only 19 IPOs per year during this period.

5

Consequently, our research has the

additional benefit of shedding light on the factors that have made AIM so attractive to

companies, both domestic and foreign.

3

The term ‘listed’is often used to refer to any company quoted on a stock exchange. However,

in this paper we focus on the distinction between the regulatory environments of the two

London markets, and so we reserve the use of this term for companies that have satisfied the

formal listing requirements of the UK Listing Authority (UKLA), which is a part of the

Financial Services Authority (FSA).

4

The headline figure for the number of Main Market companies is considerably higher: there

were 1276 entities traded at the end of 2006. But if financial vehicles, such as investment

trusts, and duplicate securities, such as preference or convertible shares, are excluded, the

number of distinct trading companies falls to around 783.

5

This figure excludes financial entities (classified by the LSE as equity investment

instruments, investment companies, investment entities and real estate).

© 2013 John Wiley & Sons Ltd

854 Tim Jenkinson and Tarun Ramadorai