Effective legal bonding reduces adverse selection: Evidence from a positive shock to public monitoring and enforcement

Akerlof (1970) predicts that in a market with information asymmetry, third-party certification increases credibility, which in turn increases liquidity, valuation, and dispersion of valuation. Of these predictions, changes in valuation dispersion have been overlooked empirically in the securities setting. This paper uses the 2013 Sino-U.S. agreement on enforcement cooperation as an increase in credibility for U.S.-listed Chinese firms. I hypothesize and find that after the agreement, high- and low-quality U.S.-listed Chinese firms’ valuations disperse. U.S.-listed Chinese firms’ liquidity rises as well. The effects are more pronounced for firms with more rigorous listing processes, positive pre-event reputations, and transparent information environments. The evidence suggests that the expectation of cooperation, which enables legal bonding, alleviates investors’ adverse selection concerns. The combined results shed light on complementarity between legal and reputational bonding.