The Rule of Law and the Pricing of Foreign Earnings

We examine the pricing of foreign earnings of U.S. multinational firms in the context of the risk of expropriation and unfair treatment by the government, measured by the rule of law index from World Bank Governance Indicators, of countries in which the international subsidiaries are located. Using 12,288 firm-years observations for the period of 1996 to 2013, we find that association of foreign earnings with returns is increasing with the average rule of law of countries in which the multinationals have subsidiaries. We find negative returns-foreign earnings association when a firm expands its operations to other countries, but such association turns out positive when the expansion occurs to countries with stronger investor protection. The results are not driven by the practices by earnings management nor by the strength of legal protection from expropriation by corporate insiders. Our results are robust to alternative empirical specifications and to the concern of endogenous relationship between market valuation and multinational choice of locating foreign subsidiaries to the high rule of law region