Investor Protection and the Role of Firm‐Level Financial Transparency in Attracting Foreign Investment

Published date01 August 2015
Date01 August 2015
The Financial Review 50 (2015) 393–434
Investor Protection and the Role
of Firm-Level Financial Transparency
in Attracting Foreign Investment
Bowe Hansen
Pamplin Collegeof Business, Virginia Tech University
Mihail K. Miletkov
Paul Collegeof Business and Economics, University of New Hampshire
M. Babajide Wintoki
School of Business, University of Kansas
We ask if companies can attract foreign equity capital by improving the transparency of
their financial statements. Using a large panel of firms across 51 countries outside the United
States, we show that the answer is yes, but only in countries with relatively high levels of in-
vestor protection. In countries with poor investor protection, unilaterally increasing firm-level
transparency has no effect on foreign ownership.Furthermore, our results indicate that in coun-
tries with higher levels of investor protection, the positive association between transparency
and foreign ownership is stronger following a country’sadoption of the International Financial
Reporting Standards.
Correspondingauthor: Paul College of Business and Economics, University of New Hampshire, Durham,
NH 03824; Phone: (603) 862-3331; E-mail:
We are grateful for the research support of Virginia Tech University, the Universityof New Hampshire,
and the University of Kansas. We appreciate comments from Valaria Vendrzyk (the AAA discussant),
David Volkman(the Southern Finance Association discussant), Bryan Cloyd, Marc Lipson, Mitch Oler,
and workshop participants at Virginia Tech University, the 2012 AAA Annual Meeting, and the 2013
Virginia Accounting Research Colloquium, as well as from two anonymousreferees.
C2015 The Eastern Finance Association 393
394 B. Hansen et al./The Financial Review 50 (2015) 393–434
Keywords: foreign ownership, home bias, financial transparency, institutional development,
investor protection
JEL Classifications: G32, G34
1. Introduction
Access to foreign equity capital provides benefits for individual firms and for
entire countries. At the firm level, foreign investors expand the firm’s shareholder
base and reduce its cost of capital, and at the country level, foreign investment in-
creases aggregate investment and promotes economic growth.1Despite the fact that
over the past three decades many of the direct and indirect barriers to foreign port-
folio investment have been lifted, the observed levels of foreign investment are still
significantly below what is considered optimal under contemporary finance theory
(French and Poterba, 1991; Tesar and Werner, 1995; Ahearne, Griever and Warnock,
2004; Chan, Covrig and Ng, 2005). One of the main explanations for this “home
bias” in investors’ portfolio allocation decisions is the higher level of information
asymmetry that investors face when investingabroad. We examine whether firms can
attract foreign investors by implementing more transparent financial reporting prac-
tices, and the effect that the level of investor protection in the firm’s home country
has on the relationship between financial transparency and foreign ownership.
Prior literature suggests that a country’s overall level of investor protection,
mandatory adoption of International Financial Reporting Standards (IFRS), and firm-
level financial transparency are important determinants of aggregate and firm-level
foreign investment (Aggarwal,Klapper and Wysocki, 2005; Leuz, Lins and Warnock,
2009; Khurana and Michas, 2011; Florou and Pope, 2012).2However, our study is
the first to examine the interaction between country-level investor protection and
changes in firm-level financial transparency, and the effect this interaction has on
a firm’s ability to attract foreign investment. In other words, our study seeks to
answer the question of what happens to foreign ownership, within an individual firm,
when the firm’s levelof financial transparency changes, given the prevailing level of
overall investor protection in the firm’s home country. This is an important research
question because any differences in the association between firm-level transparency
and foreign ownership in countries with strong investor protection (as compared
1A partial list of studies examining the effects of foreign equity investment on firm- and country-level
outcomes includes: Bekaert and Harvey (2000), Blair Henry (2000a,b, 2003), Chari and Blair Henry
(2004), Bekaert, Harvey and Lundblad (2005, 2006), Moshirian (2008), and Huang and Shiu (2009),
among others.
2One potential limitation of these prior studies is that most of them are based exclusively on foreign
investments by U.S. institutional investors. In contrast, our study is based on different types of foreign
investors (institutional investors,governments, individuals, etc.) from multiple countries.
B. Hansen et al./The Financial Review 50 (2015) 393–434 395
to that in countries with poor investor protection) have direct implications for firm
management. Indeed, the biggest contribution of our paper is to demonstrate that the
ability of individual firms to use financial reporting transparency as a mechanism for
attracting foreign equity investment can be significantly constrained (or enhanced)
by the level of investor protection in the firm’s home country.
Using three different proxies for investor protection, we show that the positive
relationship between firm-leveltransparency and foreign ownership is driven by firms
located in countries with higher levels of investor protection. In countries where in-
vestor rights are poorly protected and the risk of minority shareholder expropriation
is greater, firm-level financialtransparency does not significantly affect the portfolio
allocation decisions of foreign investors. These results hold across different model
specifications and estimation methods, and are robust to the use of alternative mea-
sures of financial transparency. Firm-level transparency and country-level investor
protection turn out to be complements rather than substitutes. If a firm is located in
a strong investor protection country, it can increase foreign ownership by increasing
the transparency of its financial statements. If the firm is in a weak investorprotection
country, increasing transparency has no effect of foreign ownership.
There are several potential explanations for our findings. One possibility is that
in countries with weak investor protection, foreign investors question the credibility
of financial reporting of all firms regardless of their level of transparency. Another
possibility is that in countries with lower levels of investorprotection, financial trans-
parency may not necessarily reduce the risk of minority shareholder expropriation,
which may be the main deterrent to foreign equity investment. Johnson, La Porta,
Lopez-de-Silanes and Shleifer (2000) show that the various self-dealing transactions
that company insiders and controlling shareholders engage in (such as transfer pric-
ing, excessive compensation, loan guarantees, asset sales, and dilution) are not illegal
in many countries. Therefore, in these countries, even if foreign investors are better
able to identify potential cases of minority shareholder expropriation in firms with
more transparent financial reporting practices, they may still be reluctant to provide
capital to these firms due to the lack of legal recourse available to them.
Our findings indicate that in their quest for foreign capital, firms are captiveto the
investor protection environment in their home countries. In countries where investor
rights are better protected, increasing firm-level financial transparencyis an effective
mechanism for attracting foreign equity investors. On the other hand, in countries
where investor rights are not adequately protected, firms are unable to attract foreign
shareholders by unilaterally committing to higher levels of financial transparency.
Therefore, in order to attract foreign equity investment in their firms, countries
need to make more substantial investments in the legal and extra-legal institutions
protecting investor rights. Our results also support and extend the theoretical and
empirical arguments in Doidge, Karolyi and Stulz (2007). While their study does
not explicitly consider foreign ownership, they argue that below a threshold level
of investor protection and economic development, individual firm characteristics
explain very little of investor perception of a firm’s governance quality, and that only

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