The Value of Offshore Secrets: Evidence from the Panama Papers James O’Donovan† Hannes F. Wagner‡ Stefan Zeume †‡ INSEAD Bocconi University University of Michigan First Draft: April 19, 2016 This Draft: May 29, 2017 We thank John Barrios (discussant), Morten Bennedsen, Jennifer Blouin (discussant), Art Cockfield (discussant), Alexander Dyck (discussant), Julian Franks, John Gallemore, Nicola Gennaioli, Jim Hines, Niels Johannesen, Karl Lins, Colin Mayer, Tom Neubig (discussant), Kasper Meisner Nielsen (discussant), Bastian Obermayer (Süddeutsche Zeitung), Marco Ottaviani, Paolo Pasquariello, Kai Petainen, Uday Rajan, Fabiano Schivardi, Andrei Shleifer, Tyler Shumway, Joel Slemrod, Sheridan Titman, and Luigi Zingales for insights that benefitted this paper. We also thank participants at ABFER 2017, the Texas Finance Festival 2017, the Drexel Corporate Governance Conference 2017, the Texas/Waterloo Tax Symposium 2016, the National Tax Association Annual Conference 2016, the Italian Economic Association Annual Conference 2016, and seminar participants at American University, Bonn University, Carnegie Mellon University, Concordia University, McGill University, and the University of Michigan (Finance, Public Finance). We are indebted to the International Consortium of Investigative Journalists for providing access to the Panama Papers data. Zeume gratefully acknowledges financial support from the Mitsui Life Financial Research Center. † Department of Finance, INSEAD, [email protected]. ‡ Department of Finance, Bocconi University, [email protected]. ‡† Department of Finance, University of Michigan, [email protected]. The Value of Offshore Secrets: Evidence from the Panama Papers Abstract We use the data leak of the Panama Papers on April 3, 2016 to study whether and how the use of offshore shelters affects firm value. We find that the leak erases $135 billion in market capitalization among 397 public firms that we trace as users of offshore vehicles exposed in the leak. These firms use offshore vehicles to finance corruption and aggressively avoid taxes, which increases firm value, but also to expropriate shareholders. Firms implicated by the leak consequently show lower sales from perceptively corrupt regions and lower tax aggressiveness. On net, offshore sheltering enhances firm value by promoting potentially illegal activities that go beyond tax avoidance. Offshore service providers facilitate such activities. JEL Classification: G32, G38, H25, H26 Keywords: Panama Papers, tax havens, offshore vehicles, corruption, tax evasion. “The archetypal tax haven may be a palm-fringed island, but […] there is nothing small about offshore finance. If you define a tax haven as a place that tries to attract non-resident funds by offering light regulation, low (or zero) taxation and secrecy, then the world has 50-60 such havens. These serve as domiciles for more than 2m companies and thousands of banks, funds and insurers. Nobody really knows how much money is stashed away.” The Economist Feb 13, 2013 Tax haven sheltering is a significant global phenomenon. Estimates of global offshore assets range from $7-9 trillion (Zucman 2015, BCG 2014) to $21-32 trillion (Tax Justice Network 2012). Among the routine users of tax havens are multinational corporations. In our sample of 23,540 global public firms, almost one in four have subsidiaries in tax havens. For the largest 1,000 global firms, this number increases to three in four. S&P 500 firms are believed to hold $2.4 trillion offshore.1 Despite their wide-spread use among corporations, little is known about whether corporate offshore vehicles create firm value or not. Desai, Dyck, and Zingales (2007) provide a theoretical framework for the costs and benefits of offshore vehicles. In their model, the veil of secrecy associated with offshore vehicles can reduce value by allowing insiders to divert corporate resources, for which prominent cases such as Enron and Parmalat provide anecdotal evidence.2 At the same time, secret offshore vehicles can also create value because they may help reduce corporate taxes and facilitate making hidden bribe payments to win business. Providing evidence on the value created by secret offshore activities is challenging because such activities are inherently unobservable. To tackle this observability problem, we exploit one of the largest data leaks to date, the 2016 leak of the Panama Papers. On April 3, 2016, 1 Zucman (2015) and BCG (2014) provide estimates for 2014 and 2013, respectively. Estimates by the Tax Justice Network (2010) are for 2010. S&P 500 firms’ cash holdings are estimates from the Economic Policy Institute (2016) for 2015. 2 Enron’s CFO used a sophisticated offshore web to tunnel $42 million out of the firm. Similarly, Parmalat’s founder used offshore entities to expropriate $620 million from the firm. 1 the news media started reporting a leak of confidential documents concerning the business activities of Mossack Fonseca & Co., a Panama-based law firm and provider of corporate services. These so-called Panama Papers comprise 11.5 million documents and provide insights into the operations of roughly 214,000 shell companies that were incorporated in tax havens around the world over the past 45 years. Thousands of news reports published by over 100 media organizations with access to the Panama Papers data stress that the use of these offshore vehicles goes well beyond tax avoidance.3 We use the leaked data to identify publicly listed firms as users of offshore vehicles. In an event study, we then compare the returns of these firms to those of other firms around dates relevant to the leak. If sheltering is used for bribe payments or tax evasion, the unexpected leak should be associated with negative returns among firms exposed to the leak because the leak may reduce future cash flows from such activities or result in costly regulatory fines for past activities. If instead offshore structures are used to divert resources out of the firm at shareholders’ expense, the leak should lead to an increase in value because the transparency brought about by the leak reduces such activities. Our empirical analysis is based on a data set of publicly traded firms that we connect to the Panama Papers. Specifically, we start with 23,540 publicly traded firms from 73 countries. These firms, obtained from Orbis, have more than 1.3 million subsidiaries across 211 sovereign and non- sovereign territories and more than 1.8 million directors. We then match the subsidiaries, directors, and directors of subsidiaries of public firms to the leaked data, which cover 212,845 vehicles, their 144,791 officers, and 12,599 intermediaries. Our matching process, which we describe in detail 3 See, for example, “The Panama Papers: How the world’s rich and famous hide their money offshore,” April 3, 2016, The Guardian (retrieved April 14, 2016). 2 below, identifies 397 public firms as users of offshore vehicles incorporated by Mossack Fonseca & Co. These firms are spread across the globe and operate in a wide range of industries. The firms tend to be large, have more international operations, and are more exposed to perceptively corrupt countries, particularly where country leaders are implicated by name in the leaked data. Our results show that the 397 firms connected to the Panama Papers experience significantly negative returns around three event dates associated with the leak. These event dates are April 3, 2016 (news organizations start reporting the leak), April 26, 2016 (the International Consortium of Investigative Journalists (ICIJ) announces a database of the leaked data will be made public), and May 9, 2016 (the database is made public). In economic terms, the leak wiped out $135 billion in market capitalization among firms with exposure to the revelations in the Panama Papers.4 This reflects a drop in firm value of 0.7% relative to same-country and same- industry firms without such exposure. We find that the decline in value is driven by firms for whom the leak uncovers secret (as opposed to observable) offshore activities and by firms whose offshore activities are intense and recent.5 Our results also hold in several alternative event study tests. Next, we examine potential drivers of the change in firm value associated with tax haven sheltering. Judging from the news reports following the Panama Papers leak, the most prevalent uses of secret offshore vehicles among publicly traded firms are the financing of corrupt activities and tax evasion.6 Two examples of large public firms that were linked to corruption by the Panama Papers received particularly wide news coverage. One firm, a German conglomerate, used offshore 4 For this calculation, we multiply each firm’s market valuation at the end of 2015 by its cumulative abnormal return during our event windows. We obtain quantitatively similar results when we instead multiply firms’ market value at the end of 2015 by the average percentage drop in firm value net of country and industry fixed effects. 5 A further explanation for the drop in firm value might be that firms’ cost of capital increases. However, we do not find evidence of changes in equity betas in firms with Panama Papers exposure. 6 Outside the scope of our paper, the Panama Papers also contain data on the use of offshore vehicles by individuals and legal entities other than publicly traded firms (such as private firms and governing bodies). 3 vehicles, some of them operated by Mossack Fonesca & Co., to run slush accounts that were used to bribe