Expropriation by corporate insiders and board effectiveness in an emerging economy

Chapter 2 begins by discussing the institutional environment concerning China‟s state-dominated capital market, corporate ownership structure and fund misappropriation transactions betwe

EXPROPRIATION BY DOMINANT SHAREHOLDERS AND

BOARD EFFECTIVENESS IN AN EMERGING ECONOMY

NATIONAL UNIVERSITY OF SINGAPORE

2009

ACKNOWLEDGEMENTS

I would like to thank my advisor, Professor Andrew Delios, for his

help at every step of my dissertation progress The innovative ideas, thought,

and depth of perceptions of Professor Delios have added incredible value to

this dissertation and I am sincerely grateful Furthermore, his continuous

guidance and encouragement made the timely completion of this dissertation

possible

I would like to extend my appreciation to Professor Edward Zajac and

Prof Ishtiaq P Mahmood who were instrumental in shaping the direction of

this dissertation My discussions with them led to several breakthroughs in this

project The innovative ideas, resourcefulness, and sincere enthusiasm of my

committee members: Professor Nitin Pangarkar and Dr Krishna Udayasankar,

were also invaluable

I also want to thank all the other faculty members and doctoral students

at National University of Singapore who have in many ways shaped my

academic perspective and have guided me through this journey

Finally, I would like to thank my husband and my newborn son

Without your love and unwavering support, this journey would not have been

possible I know that this was not my journey alone, and that you were there

by my side – quietly, gently, continually pushing me onwards And for that I

will be forever grateful

TABLE OF CONTENTS ACKNOWLEDGEMENTS ii

TABLE OF CONTENTS iii

SUMMARY vi

LIST OF TABLES ix

LIST OF FIGURES x

LIST OF SYMBOLS xi

CHAPTER 1 – INTRODUCTION 1

1.1 Overview 1

1.2 Research Questions 5

1.3 Contribution 8

1.4 Organization of Dissertation 9

CHAPTER 2 – INSTITUTIONAL ENVIRONMENT 11

2.1 The Development of China Stock Market 12

2.2 Regulatory Response 15

2.3 Ownership Structure 17

2.3.1 Tradable shares versus non-tradable shares 19

2.3.2 A-shares, B-shares, and H-shares 24

2.4 Agency Conflict between Dominant Shareholders and Minority Shareholders 26

2.4.1 Related-party transactions 26

2.4.2 Prevalence of fund misappropriation transactions initiated by dominant shareholders 28

2.4.3 Regulations governing fund misappropriation transactions 31

2.4.4 The case of Guangzhou Nanhuaxi Industrial Corporation 33

2.5 The Board of Directors 37

2.5.1 Board responsibilities 39

2.5.2 Board composition 40

2.5.3 Independent directors 42

2.6 Supervisory Board 47

2.7 Conclusion 50

CHAPTER 3 – DOMINANT SHAREHOLDERS‟ EXPROPRIATION ACTIVITIES: INCIDENCE AND THEIR COSTS TO LISTED COMPANIES 54

3.1 Introduction 54

3.2 Theory and Hypotheses 59

3.2.1 Ownership structure 60

3.2.2 The board of directors 65

3.3 Data and Methodology 67

3.3.1 Regulations on non-operating fund transfer in Chinese listed companies 67

3.3.2 Data 69

3.3.3 Dependent variables 70

3.3.4 Independent variables 71

3.3.5 Control variables 72

3.3.6 Statistical model 74

3.4 Results 75

3.5 Additional Analysis 79

3.5.1 Impact of foreign retail investors 79

3.5.2 Impact of dominant shareholder‟s portfolio considerations 80

3.5.3 Interaction between large shareholders 81

3.6 Discussion and conclusion 84

CHAPTER 4 - THE ARENAS AND SOURCES OF INDEPENDENT DIR EC TORS ‟ C HALLENG ING INVO LVEMENT IN CORPORATE DECISION-MAKING 88

4.1 Introduction 88

4.2 Arenas of Independent Directors‟ Challenging Involvement 91

4.2.1 Monitoring executive performance 92

4.2.2 Protecting corporate resources 93

4.2.3 Providing counsel to executives 94

4.3 Hypothesis Development 96

4.3.1 Business expertise 96

4.3.2 Support expertise 98

4.3.3 Organizational power 101

4.3.4 Social influence from corporate insiders 103

4.3.5 The market for influential directors 107

4.4 Data and Methodology 110

4.4.1 Sample 110

4.4.2 Dependent variables 111

4.4.3 Independent measures 113

4.4.4 Control variables 115

4.5 Results 118

4.5.1 Main results 118

4.5.2 Results on the market for influential directors 124

4.5.3 Independent directors‟ impact on preventing dominant shareholders from engaging in fund misappropriation transactions: a complimentary analysis 127

4.6 Discussion 130

4.6.1 Contributions 132

4.6.2 Limitations and future research 134

4.6.3 Implications 137

4.6.4 Conclusion 140

BIBLIOGRAPHY 157

SUMMARY

This dissertation investigates dominant shareholders‟ expropriation

activities and board effectiveness in an emerging economy Chapter 1 provides

an overview of the dissertation and states its major contribution to the

corporate governance literature and to the theoretical developments in

strategic management and organization theory

Chapter 2 begins by discussing the institutional environment

concerning China‟s state-dominated capital market, corporate ownership

structure and fund misappropriation transactions between listed companies and

their dominant shareholder It also discusses the institutions of the board of

directors and the supervisory board as a potential solution to China‟s corporate

governance problems

As the external merger and takeover market for corporate control

seldom exists and there is weak legal protection for investors in emerging

markets, checks to corporate insiders‟ expropriation activities are mainly

provided by internal governance mechanisms Based on the tenets of agency

theory and social embeddedness perspective, Chapter 3 addresses how

corporate ownership structure and directors‟ affiliation with the dominant

shareholder affect the incidence of that dominant shareholder‟s expropriation

activities and the cost of such activities to a listed company Specifically, this

chapter examines whether the interests of state shareholders, foreign

blockholders and corporate directors are consistent with the incidence and

consequences of expropriation activities initiated by dominant shareholders

Regressions using data on all Shanghai-listed companies in 2004 and

2005 lend support to the predictions that the incidence of a dominant

shareholder‟s expropriation activities decreases with the presence of foreign

blockholders and increases with the percentage of affiliated directors, while

the cost of such expropriation activities positively relates to the level of state

ownership Additional analysis is performed regarding the impact of foreign

retail investors, dominant shareholders‟ portfolio considerations and other

non-dominant large shareholders

As the board of directors is the highest internal control mechanism

responsible for monitoring the activities of dominant shareholders, it is

important to investigate the effectiveness of directors, especially independent

directors In addition to their limited power, independent directors are

confronted with persistent challenges in making meaningful contribution to

corporate decision-making Drawing insights from multiple theoretical

perspectives, Chapter 4 explores how the challenging involvement of an

independent director in corporate decision-making depends on the availability

of the director‟s intellectual capital; social influence received from corporate

insiders and his/her organizational power It identifies three arenas that an

independent director is expected to provide challenging opinions: “monitoring

executive performance”, “protecting corporate resources”, and “providing

counsel to executives”

Empirical analysis of Chapter 4 utilizes a sample of 2,806 independent

directors from all Shanghai-listed companies in 2005 Using non-acceptance

opinions of these independent directors released in corporate annual reports,

this chapter finds that intellectual capital structure and social context of

independent directors, not simply their presence or functional background,

deliver an important impact on corporate decision-making By examining the

impact of independent directors‟ provision of challenging opinions on their

turnover in the focal company, this chapter suggests that micro-social factors

involved in the relationship between corporate insiders and independent

directors, by reducing the objectivity of independent directors‟ opinions, may

ultimately compromise corporate control.

LIST OF TABLES

Table 1 An Overview of China Stock Market 1998 - 2008 14

Table 2 Ownership Structure of Chinese Listed Companies 2003 – 2008 19

Table 3 Prevalence of Fund Misappropriation Transactions by Dominant

Shareholders in Shanghai-listed Companies 2001-2005 30

Table 4 A List of Companies that were Delisted Due to Fund Misappropriation

Transactions (Jun 2001 to September 2005) 36

Table 5 Board Composition of Chinese Listed Companies 1999 - 2008 41

Table 6 Composition of the Supervisory Boards in Chinese Listed Companies

1999 - 2008 48

Table 7 Descriptive Statistics and Correlation Coefficients 74

Table 8 Heckman Selection Regression of Incidence of Fund

Misappropriation and Accrued Interest on Funds Misappropriated 78

Table 9 Additional Analysis Using Heckman Selection Regression on

Incidence of Fund Misappropriation and Accrued Interest on Funds

Misappropriated 83

Table 10 Independent Directors' Opinions and Factor Analysis Result 112

Table 11 Descriptive Statistics and Correlation Coefficients 117

Table 12 OLS Regression on Determinants of an Independent Director's

Challenging Opinions in the Arena of "Monitoring Executive Performance"

119

Table 13 OLS Regression on Determinants of an Independent Director's

Challenging Opinions in the Arena of "Protecting Corporate Resources" 120

Table 14 OLS Regression on Determinants of an Independent Director's

Challenging Opinions in the Arena of "Providing Counsel to Executives" 122

Table 15 Negative Binomial Regression Predicting How Soon an Independent

Director Would Leave the Current Board 126

Table 16 Robustness Check on Independent Directors' Challenging

Involvement in the Arena of "Protecting Corporate Resources" By Examining

their Impact on Prevent Fund Misappropriation Transactions 129

Table 18 Industry Distribution of Firms in the Sample 141

LIST OF FIGURES

Figure 1 Prevalence of State-owned Shares in Chinese Listed Companies 2000

– 2008 20

Figure 2 The Chinese-Style State Pyramid 21

Figure 3 Distribution of Foreign Shares in Chinese Listed Companies 1999 -

2008 25

Figure 4 Related-party Transactions in Companies Listed on Shanghai Stock

Exchange 28

Figure 5 Distribution of Related Parties of Shanghai-listed Companies

involved in Related-party Transactions (2005) 28

Figure 6 Amount of Funds Misappropriated by Dominant Shareholders in

Shanghai-listed Companies 2003 - 2005 30

Figure 7 Ownership Pyramid of Guangzhou Nanhuaxi Industrial Corporation

34

Figure 8 Fund Misappropriation Transactions between Nanhuaxi Industrial

Corporation and Its Dominant Shareholder or Affiliates of the Dominant

LIST OF SYMBOLS

ADR American Depository Receipt

CEO Chief Executive Officer

CSMAR China Stock Market and Accounting Research

CSRC China Securities Regulatory Commission

IPO Initial Public Offering

OECD Organization for Economic Co-operation and Development

R&D Research & Development

SCSC State Council Securities Commission

SEC Securities and Exchange Commission

SOE State-owned Enterprises

CHAPTER 1 – INTRODUCTION 1.1 Overview

Corporate governance issues arise in an organization whenever the following two conditions are present: first, there is an agency problem involving members of the organization which might be owners, managers, workers or consumers; second, transaction costs are such high that this agency problem cannot be dealt with through a contract (Hart, 1995)

In recent years, corporate stakeholders and academic scholars have expressed strong concern about dominant shareholders‟ expropriation of minority shareholders (La Porta, Lopez-de-Silanes, & Shleifer, 1999) Johnson,

La Porta, Lopez-de-Silanes and Shleifer (2000) use the term “tunneling” to define the transfer of assets and profits out of firms for the benefit of their dominant shareholders Tunneling can take many forms, including outright theft or dilutive share issues that discriminate against minority shareholders Such activities are perceived to be particularly serious in companies with a concentrated ownership structure, or in countries where there is a thin market for corporate control (Dyck & Zingales, 2004), or in countries where there is poor or weak legal protection for investors (Nenova, 2003)

The corporate governance and financial economics literature have started to explore the effectiveness of institutional mechanisms in preventing dominant shareholders from engaging in expropriation activities (Johnson et al, 2000; La Porta, Lopez-de-Silanes, & Shleifer, 2002) Some researchers have examined performance consequences of the dominant shareholders‟ expropriation activities (Atanasov, 2005; Dyck & Zingales, 2004) However, only a few studies have examined how internal corporate governance

mechanisms, such as CEO incentive arrangements (Beatty & Zajac, 1994) and

a structurally independent board of directors (Claessens, Djankov & Lang, 2000; Rajan & Zingales, 2003), can mitigate the agency conflicts between minority shareholders and dominant shareholders

Much of the corporate governance literature draws insights from the agency theory and examines the impact of ownership structure and ownership concentration on the dominant shareholders‟ expropriation behavior Although some posit that high cash-flow rights provide dominant shareholders with too much discretionary power over resource allocation and permit them to capture private benefits at the expense of small shareholders (Bennedson & Wolfenzon, 2000; Burkart, Gromb, & Panunzi, 1998), others point out that high cash-flow rights motivate dominant shareholders to monitor managerial behavior and distribute dividends (Jensen & Meckling, 1976) Moreover, in companies which have several significant shareholders, non-dominant large shareholders may form a coalition against the dominant shareholder and that coalition could constitute a functioning mechanism to protect the interests of small investors once it obtains sufficient voting rights (Bennedsen & Wolfenzon, 2000; La Porta et al, 1999)

At the heart of the corporate governance reform is the common interest

on the effectiveness of the board of directors Williamson (1985) argues that the board of directors is primarily a governance structure safeguarding between firms and owners of equity capital As the highest internal control mechanism responsible for monitoring the actions of corporate insiders (Fama

& Jensen, 1983), the board of directors may either curb or take a blind eye to the expropriation activities initiated by corporate insiders Academic research

has largely focused on examining how specific dimensions of board structure, such as the proportion of independent directors (Beasley, 1996; Hermalin & Weisbach, 1991, 2001) and the separation of CEO and board chair positions, can affect the relative power and decision-making tendencies in the CEO-board relationship in widely-held companies in developed countries (Finkelstein & Hambrick, 1989; Mallette & Fowler, 1992) For example, adopting insights from the structuralistic view of power, some researchers find that corporate boards that are structurally more independent from the management are better able to control management decision-making on behalf

of the shareholders (Fama & Jensen, 1983; Westphal, 1998) However, little is known on this issue with regard to companies with a concentrated ownership structure where the agency conflict between the dominant shareholder and minority shareholders prevails over the conflict between managers and shareholders (Shleifer & Vishny, 1997)

For independent directors, the performance of the companies they oversee has almost no impact on their personal wealth because they have limited ownership stake in these companies (Hambrick & Jackson, 2000; Patton & Baker, 1987) and they only receive a fixed amount of director fee The inconsistent findings on the association between the number/percentage of independent directors and corporate financial performance (MacAvoy & Millstein, 2003) suggest that independent directors can‟t effectively safeguard the interests of shareholders without appropriate motivation, intellectual capital and independence Therefore, the question of how to improve the effectiveness of independent directors draws increasing attention from the

academia and the media, especially in the wake of various corporate governance scandals

This dissertation aims to explore two sets of questions: how do corporate ownership structure and directors‟ affiliation with the dominant shareholder affect the incidence of the dominant shareholder‟s expropriation activities and the cost of these activities to listed companies? And what are the arenas and sources of independent directors‟ challenging involvement in corporate decision-making?

The empirical context for this dissertation covers all companies listed

on the Shanghai Stock Exchange in 2004 and 2005 Choosing a large sample

of listed companies in a single emerging economy rather than using country data is relevant to my research questions In contrast to cross-country analysis investigating the potential that a country‟s laws offer for the protection for non-controlling shareholders from being expropriated (Claessens et al., 2002; La Porta et al, 1998, 2002), this dissertation takes an in-depth approach by analyzing firms that each face the same set of legal restrictions, but have chosen to adopt different ownership structure and governance practices

cross-The China stock market was initially established by the government to partially, and eventually fully, privatize its state-owned enterprises (SOEs) As the privatization of state-owned equities goes on, more shares are held in private hands, and an increasing number of stakeholders are willing to take an active role in monitoring dominant shareholders‟ behavior By the end of 2008, the China stock market had 1,604 domestically listed companies and a market capitalization of RMB 12.14 trillion (approximately USD 1.78 trillion)

Concentrated ownership structure is a prominent organizational form (Firth, Fung, & Rui, 2006; Mesngistae & Xu, 2004) The dominant shareholder is usually the state or a legal entity, although there are a growing number of cases where the dominant shareholder is a private firm or an institution

There are some weaknesses in the regulatory framework in China with respect to the agency conflicts between corporate insiders and minority shareholders and the effectiveness of corporate boards (Ho, 2002; Lin, 2000) First, the China Securities Regulatory Commission (CSRC) lacks both the necessary resources and the power of investigation and prosecution to effectively execute its rules and regulations For example, national laws including the Company Law and Securities Law have general provisions on directors‟ duties and civil liabilities, which can only be solved by administrative directives released by the CSRC If a case on suspected infringements is brought to the courts, the courts are not subject to the Guidance Opinions released by the CSRC Second, access to listing in China‟s stock market is strictly administered by governmental authorities, and the regulations are asymmetrically in favor of SOEs and other companies that hold close ties to the government As a result, although the CSRC issued the Guidance Opinion on the Establishment of An Independent Director System in

2001, board independence is greatly compromised by the dominance of state representatives on the board

1.2 Research Questions

To explore how ownership structure and the board of directors influence the level of agency conflicts between the dominant shareholder and minority shareholders, and to investigate ways to enhance the challenging

engagement of independent directors in corporate decision-making, this dissertation addresses two questions in the context of China‟s capital market

 How do ownership structure and directors‟ affiliation with the dominant shareholder affect the incidence of fund misappropriation transactions initiated by the dominant shareholder and the cost of these transactions to the listed company?

 What are the arenas and sources of independent directors‟ challenging involvement in corporate decision making?

Chapter 3 addresses the first question By integrating the agency theory and the social embeddedness perspective, I investigate the impact of state ownership, foreign blockholders as well as affiliated directors on the dominant shareholders‟ expropriation activities

Regressions using archival data on all Shanghai-listed companies over the period 2004-2005 lend support to the predictions that the incidence of a dominant shareholder‟s expropriation activities decreases with the presence of foreign blockholders and increases with the percentage of affiliated directors; and the cost of these expropriation activities to the listed company increases with the level of state ownership Additional analyses are performed regarding the impact of foreign retail investors, the dominant shareholder‟s portfolio considerations and the interaction between the dominant shareholder and other large shareholders

The second question is examined in Chapter 4 Previous studies have concluded that independent directors are expected to effectively constrain corporate insiders from instigating and perpetrating frauds, discipline CEOs in firms with poor performance, and influence the processes of strategic choice,

change and control However, in addition to their limited power, independent directors are confronted with persistent challenges in making meaningful contribution to corporate decision making As a response, I examine to what extent the challenging involvement of an independent director in corporate decision making depends on the availability of the director‟s intellectual capital, social influence received from corporate insiders, and the individual‟s organizational power Based on the insights from previous studies and independent directors‟ responsibilities in China, I specify three arenas of corporate decisions on which an independent director is expected to deliver challenging opinions: “monitoring executive performance”, “protecting corporate resources”, and “providing counsel to executives” And I identify the matches between the expected involvement of an independent director and the required sources to provide such involvement, and explore how an independent director‟s challenging involvement in different arenas affects the individual‟s turnover in the focal company

To conduct empirical analysis, I utilize a sample of 2,806 independent directorships from all Shanghai-listed companies in 2005 The findings suggest that the intellectual capital structure and social context of independent directors deliver a significant impact on these directors‟ challenging involvement in the three arenas of corporate decision-making By examining the determinants and consequences of social influence and reciprocity, I suggest that micro-social factors involved in the relationship between corporate insiders and independent directors, by affecting the delivery of independent directors‟ independent and challenging opinions on key corporate decisions, ultimately compromise corporate control

1.3 Contribution

In addition to the individual contributions made by each chapter as outlined above, this dissertation makes the following overall contributions First, previous studies on the board of directors have relied on the agency theory and favor the board of directors‟ control role at the expense of its service and strategic roles (Hillman & Dalziel, 2003) In this dissertation, I propose a multiple lens‟ approach to obtain a richer understanding of the influence of corporate directors, and independent directors in particular Because of the rather confidential nature of board activities, I measure independent directors‟ performance by identifying various board decisions that relate to their roles and responsibilities

Second, previous literature has found that dominant shareholders‟ expropriation of minority shareholders result in consequences such as a higher premium for voting shares (Nenova, 2003; Zingales, 1994), fewer IPOs (La Porta et al, 1997), a lower company valuation (Claessens et al, 2000; La Porta

et al, 1999), and an inefficient allocation of investments (Wurgler, 2000) This dissertation takes the lead to explore how internal governance mechanisms including ownership structure and the board of directors influence the level of agency conflicts between the dominant shareholder and minority shareholders,

in a setting situated in an emerging economy

Much of the academic literature has attempted to measure the expropriation of minority shareholders indirectly (Bertrand, Mehta & Mullainathan, 2002; Claessens et al, 2002; Faccio, Lang & Young, 2001; La Porta et al, 2000b, 2002) Consequently, there is little direct and systematic evidence on the specific transactions through which such expropriation occurs

This dissertation adds value to the literature by using fund misappropriation transactions initiated by the dominant shareholder as a proxy for that shareholder‟s expropriation behavior and examines both the incidence of such transactions and their costs to listed companies

Finally, previous studies emphasize the impact of specific changes in board structure on corporate outcomes such as CEO compensation, corporate diversification and firm performance (Hermalin & Weisbach, 1991; Westphal

& Zajac, 1994) However, this dissertation devotes sufficient attention to the black box of board process, and emphasizes the roles of individual characteristics and social context in determining the performance of independent directors Furthermore, this dissertation integrates our understanding of the various arenas in which independent directors can exert valuable influence, and identifies the need for a match between the expected challenging involvement of independent directors, and the required intellectual capital and organizational power to initiate these involvements

1.4 Organization of Dissertation

This chapter provides an overview of the two essays discussed in this dissertation It states the major contributions of this dissertation to the corporate governance literature and to the theoretical developments in strategic management and organization theory Chapter 2 begins by discussing the institutional environment concerning China‟s state-dominated capital market, ownership structure of listed companies and the most prominent problem associated with it, which is the fund misappropriation transaction between a listed company and its dominant shareholder, and then proceeds to

discuss the institutions of the board of directors and the supervisory board as a potential solution to the corporate governance problems in China Chapters 3 and 4 address the two research questions respectively I present each of the two essays as a complete empirical paper that could potentially function as a stand-alone piece of research

CHAPTER 2 – INSTITUTIONAL ENVIRONMENT

Corporate governance is a broad subject, intertwined with many areas

of financial reform The western concept of corporate governance centers on the principles of transparency, accountability, and fairness And the main mechanisms of corporate governance to look for include an independent board

of directors, treatment of minority shareholders, and coordinating the interests

of shareholders and corporate executives

Currently, the main agency problem in the U.S and U.K is between the management and outside diverse shareholders where managers pursue private benefits at the cost of the shareholders‟ interests In continental Europe and Japan, ownership is highly concentrated in the hands of main banks and financial institutions In East Asian economies where ownership is highly concentrated in the hands of controlling families, dominant shareholders are able to pursue self-interests via unchecked related-party transactions or abuses

of corporate assets, which make the main agency conflict exists between the dominant shareholder and minority shareholders

This dissertation uses China as the institutional setting With the continuous corporatization of state-owned enterprises (SOEs), rapid expansion

of the stock market and the ever increasing market awareness, coupled with a series of giant corporate scandals and accounting failures, corporate governance has become a very pressing problem in China Many governance mechanisms that firms in the U.S utilize, such as monitoring from strategic investors, external takeover threat, and managerial ownership, are uncommon among Chinese firms (Tam, 2002) And the main agency problem exists among multi-parties including state shareholders, directors, supervisors,

executives and minority shareholders Thus, the choice of China complements previous studies on corporate governance that were conducted in the context

of Anglo-American economies Furthermore, it allows me to focus on the impact of internal governance mechanisms due to the limited impact of external governance mechanisms such as the market for corporate control In contrast to cross-country analysis that investigates how national laws influence board effectiveness and protect shareholders‟ rights, this dissertation takes an in-depth approach to analyze firms that each faces the same set of legal restrictions, but has chosen to adopt different ownership structures and governance practices

After a brief description of the institutional environment concerning the development of China‟s capital market, this chapter discusses corporate ownership structure and one of the most prominent problems associated with it, which is the fund misappropriation transaction between a listed company and the company‟s dominant shareholder Then it proceeds to discuss the institutions of the board of directors with a special focus on independent directors, and the supervisory board This chapter concludes with the discussion of potential contributions of China-based studies to the general

development of corporate governance research

2.1 The Development of China Stock Market

It is virtually impossible to understand the emergence of China‟s corporate governance system without putting it into the broader context of the

1990 economic reform Before the 1990s, economic reforms in China involved the corporatization of SOEs and the adoption of profit-making objectives such

as contract responsibility systems While the government delegated increasing

autonomy to managers of the corporatized SOEs, it was unwilling to give up ownership rights Political interference in business operations was rife and managers‟ autonomy was emasculated (Firth, Fung & Rui, 2002) As a result, SOEs performed below the expectation of the government At the same time, backward equipments and facilities of SOEs motivated the government to seek

a great amount of capital to facilitate the reforms of these companies

The China stock market was initially established by the government to partially, and eventually fully, privatize its SOEs As the privatization of state-owned equities continued, an increasing number of companies became listed

on the Shanghai and Shenzhen Stock Exchanges after 1990 To be listed and thus become eligible to raise capital directly from the public, a company must take the form of a joint stock company under the Company Law - a form intended for large corporations with a widely dispersed ownership structure Companies can also go public on overseas exchanges, typically in Hong Kong and New York

Apart from the government-controlled regulatory framework that is in contrast with the administratively independent regulatory bodies in the U.S and U.K., the state monopolizes the access to equity finance in the sense that it has the final say on which firm is qualified to raise equity funds through IPOs

A firm needs to demonstrate three continuous years of profits in order to be qualified as a candidate for listing The state sets a quota for the number of listings each year and the listing selection process involves various social and political considerations (Chen et al, 1998), which are often asymmetrically in favor of SOEs and other firms that hold close ties to the government For this historical reason, the majority of Chinese listed companies originate from

restructured SOEs and the government still holds a majority of shares in these companies, either by direct shareholding or indirectly through state-owned institutions such as state investment firms, state holding firms, and state asset management agencies (Chen, 2004)

By the end of 2008, the China stock market had 1,604 domestically listed companies and a market capitalization of RMB 12.14 trillion (approximately USD 1.78 trillion) The dominant shareholder is usually the state or a legal entity (Firth, Fung & Rui, 2006), although there are a growing number of cases where the dominant shareholder is a private firm or an institution Table 1 illustrates the development of the China stock market over the period 1998 to 2008

Table 1 An Overview of China Stock Market 1998 - 2008

Source: Shanghai Stock Exchange, Shenzhen Stock Exchange

2.2 Regulatory Response

At the beginning of the reform period, China had few laws covering commercial transactions and none of them related to property rights Regulators made ad-hoc and inconsistent decisions This situation put in peril the economic reforms already underway Even after the establishment of the two stock exchanges in early 1990s, there was confusion over the roles of the three regulatory agencies: the State Council Securities Commission (SCSC),

the People‟s Bank of China (the de facto Central Bank), and the China

Securities Regulatory Commission (CSRC) To remedy for this chaotic situation, the State in 1998 reorganized the regulatory agencies that covered companies and securities business into the CSRC

As an institution of the State Council, the CSRC was established in

1990 It was granted by the Securities Law with the “authority to implement a centralized and unified regulation of the nationwide securities” (Friedman, 2002) The CSRC investigates allegations of companies and securities fraud and malpractice Examples include embezzlement by company officers and securities firms, expropriation of assets that hurt minority shareholders, false and inadequate financial disclosures, and stock market manipulation It is also responsible for advising on changes to laws, formulating regulations for the securities market, vetting listing applications, and providing supervision over companies, securities firms, investment institutions, sponsors, stock exchanges, professional bodies and individuals

In addition, the CSRC is empowered to issue opinions, guidance opinions, and other non-legally binding guidance for listed companies For example, in 2001, the CSRC issued the Guidance Opinions on the

Establishment of an Independent Director System in Listed Corporations In

2002, the CSRC and the State Economic and Trade Commission promulgated the Code of Corporate Governance, which expands the Company Law by making more detailed and explicit reference to the obligations and responsibilities of directors and shareholders In 2005, the Company Law was revised to reaffirm the independent director system Details of these opinions and guidelines will be discussed in Section 2.5.3

In the U.S., the Securities and Exchange Commission (SEC) is the single regulatory body that oversees almost all securities law-related corporate governance issues Under the protection of the U.S Constitution, the SEC has almost unrestricted investigative power to issue subpoenas nationwide against any person (Lang, 2002) If a person refuses to comply with a subpoena, the SEC can apply to the federal district court for enforcement In China, however, the CSRC lacks the necessary resources and the power of investigation and prosecution to effectively execute its rules and regulations Specifically, the CSRC differentiates its sanctions on companies into four categories: public criticism, public condemnation, official warning, and monetary fines (Mao, 2002); and enforcement actions on individuals can lead to criminal prosecution with significant penalties However, neither the Company Law nor the Securities Law has specific provisions on directors‟ duties and civil liabilities If a case on suspected infringements of directors is brought to the court, the court is not subject to the regulations or guidance released by the CSRC

Such a weak legal culture and enforcement system can easily undermine confidence in legal processes, especially in litigation against SOEs

Two main factors account for the difficulties faced by Chinese investors in seeking legal recourse (Lin, 2000) First, the cost of lawsuits is high, particularly to small shareholders The plaintiff has to re-pay the lawsuit fee to the court Therefore, small shareholders and damaged parties are often ignorant of their legal rights and recourse, and choose not to undertake expensive legal actions Second, local courts are reluctant to accept cases relating to the conflicts between dominant shareholders and minority shareholders, which are usually regarded as a company‟s „internal‟ disputes In the case of insider trading, related-party transactions, and material false statements, investors can only sue in cases in which the party has already been proved guilty by the CSRC (Hu, 2002)

Effective legislation, enforcement, judiciary process and level of sanctions are important factors in building a sound regulatory framework To maintain an appropriate level of regulation while sustaining an efficient and competitive market is the most difficult target that a regulatory body wishes to achieve While excessive regulation could lead to high transaction costs and discourage innovations, the main problem in China today seems to be more concerned with under-regulation in the enforcement and judiciary process

2.3 Ownership Structure

Concentrated ownership structure is prominent in Chinese organizations (Firth et al, 2006) According to the data compiled from 2005 annual reports of all domestically listed companies, the mean level of ownership held by the largest shareholder was 40.3 percent, while the aggregate levels of ownership held by the second to fifth and the sixth to tenth largest shareholders were only 17.2 percent and 3 percent respectively While

the main agency conflict in companies with dispersed ownership structures such as those in the U.S and U.K resides between managers and shareholders (Berle & Means, 1932; Jensen & Meckling, 1976), companies with concentrated ownership structures are characterized by the agency conflict between the dominant shareholder and minority shareholders (Claessens et al., 2000; Faccio & Lang, 2002; La Porta et al, 1998) Ownership structure affects the degree to which corporate contracts can be enforced as it affects owners‟ abilities and incentives to enforce their rights In general, La Porta et al (1998,

1999, and 2002) predict that more concentrated ownership structure would be observed in economies where property rights are not well enforced by the government

The level of ownership concentration is affected by many social, political and economic factors In China, the state controls the pace of share issues and their listing The Company Law specifies the functions and responsibilities of three institutions: the shareholders‟ general meeting, the board of directors, and the supervisory board Large shareholders are authorized to submit proposals at the shareholders‟ general meetings while minority shareholders are unable to do so, even if some of them are elected as directors It was not until October 2005 that the Company Law was revised to incorporate new rules protecting the rights and interests of minority shareholders Therefore, before the end of 2005, it was highly possible for large shareholders to infringe on the rights and interests of minority shareholders Table 2 provides summary statistics on the ownership structure

of all domestically listed companies in China Because of the process of

privatization, the mean level of state ownership decreased from 36.4 percent in

2003 to 21.3 percent in 2008

Table 2 Ownership Structure of Chinese Listed Companies 2003 – 2008

Companies Listed on Shanghai Stock Exchange Companies Listed on Shenzhen Stock Exchange

State Shares

Foreign Shares

No of Firms

Market Cap (RMB, billion)

Tradable Shares

State Shares

Foreign Shares

2.3.1 Tradable shares versus non-tradable shares

According to their tradability on the secondary market, shares issued

by Chinese companies can be categorized into two types: non-tradable shares and tradable shares Non-tradable shares include state shares, legal person shares and employee shares, while the tradable counterparts are composed of A-, B-, and H-shares

Table 2 shows that during the period 2003-2008, the percentage of tradable shares issued by all Shanghai-listed companies increased from 38.7 percent to 63.6 percent, and it increased from 41.4 percent to 55.3 percent for Shenzhen-listed companies A large proportion and excessive concentration of non-tradable shares impedes the emergence of markets for corporate control Furthermore, due to the widely dispersed nature of tradable shares, outside tradable shareholders have incentives to take a free ride The insufficiency of monitoring from outside shareholders tends to engender corporate insiders‟ discretion over resource allocation

Owners of non-tradable shares were usually sponsors when enterprises corporatized before their IPOs Non-tradable shares include both state-owned

shares and social legal person shares State-owned shares can be transferred to non-SOEs or foreign institutions and become social legal person shares upon the approval of the CSRC and the Ministry of Finance State-owned shares comprise of state shares and state-owned legal person shares which have different investment entities and equity management entities Specifically, state shares are obtained by government institutions or departments representing the central government while state-owned legal person shares are obtained by state-owned legal persons, government affiliated institutions or other state affiliates Figure 1 displays the trend of state ownership in Chinese listed companies over the period 2000-2008

Figure 1 Prevalence of State-owned Shares in Chinese Listed Companies

An application of the „pyramid‟ concept to the context of Chinese corporate reform enables the examination of the agency problem of the state in using different classes of intermediate shareholding Figure 2 provides the one that characterizes the different pyramidal mechanisms taken by the state to retain ultimate control

Figure 2 The Chinese-Style State Pyramid

State as the ultimate controlling shareholder

State direct control

Central and local government

agencies as direct controlling

shareholders

State-controlled industrial companies as controlling shareholders

State-owned investment holdings companies as controlling shareholders

Chinese listed companies

State indirect control

Specialized companies

Diversified business group

Chinese listed companies

Chinese listed

companies

Chinese listed companies

Note: The figure above illustrates the complicated pyramid structure and the associated intermediate shareholding classes the state can use to exercise its ultimate control The various intermediate control agents include government agencies, investment holdings companies, and industrial companies which can be further classified as specialized firms and diversified business conglomerates

Theoretically, it may be plausible to argue that the shorter the delegation chain between ultimate principal and downstream agents, the less efficiency loss arising from such agency problems However, such a claim does not consider the potential differences in the capability and incentives of monitoring downstream managers between government bureaucrats and SOE managers If SOE managers in intermediate controlling firms have more technical capabilities and financial or political incentives to monitor their subsidiary managers, then the latter shareholding class would outperform the former

Because of the privatization process and growth of the China stock market, the percentage of companies in which the state maintained as one of the top 10 largest shareholders decreased from 77 percent in 2000 to 62

percent in 2008, and the mean level of state ownership decreased from 36 percent in 2000 to 21 percent in 2008 Furthermore, as shown in Figure 1, the number of listed companies with concentrated state ownership decreased sharply over the period 2000 – 2008

Several problems must be taken into account before attempting to read any significance about the state ownership data First, political authorities retain many channels of control through which internal corporate matters may

be influenced even in the absence of a controlling state ownership Second, a given level of state ownership would mean a given concentration of state ownership only if state shares are all held by the same body and subject to the same will However, in practice, state shares can be held by different bodies formally representing the state but pursuing very different agendas For example, some government agencies may be purely profit-seeking, while others may use their equity stake to influence the company to fulfill certain objectives such as full employment

The prevalence of state ownership could result in three major consequences First, the state often exerts very strong political influence over listed companies on procedures such as the appointment of board members and key executives, which may impair the rights of other shareholders and the achievement of profit maximization objectives Second, state shares are held

by agencies such as the state asset management bureaus and local finance bureaus Although these agencies hold the control rights of state shares, they

do not enjoy the cash flow rights as dividends and other corporate payouts are remitted directly to the Ministry of Finance or local governments Furthermore,

if the state is allowed to sell its shares, the transfer price is set close to the

book value of the stock Thirdly, some of the bureaucrats in government agencies serve as non-executive directors in listed companies, and they may not have the required level of business acumen and industry expertise as they are selected through political processes (Zhang, 1998) Therefore, they may not be able to implement their functions effectively

A majority of Chinese listed companies are transformed from former state enterprises The typical restructuring process of a SOE in preparation for public listing is dubbed „carve-out‟ listing in the sense that the former SOE carves out a portion of profitable physical assets to establish a new company for flotation In return for the assets injected, the parent SOE receives non-tradable state shares or legal person shares in the new company, which is then listed on equity markets Since the post-restructuring state and legal person shares are not tradable on the secondary market, it presents a rapid dilution of state ownership in principle

Social legal person shares are often owned by domestic institutions including stock corporations and non-bank financial institutions through investing their legal capital in stock corporations or through an agreement on ownership transfer Unlike state-owned shares, the transfer of social legal person shares only needs approval from the CSRC If these shareholders were sponsors of the corporation before the IPO process, their shares cannot be transferred to another entity until three years after the IPO Besides their voting power on important corporate decisions such as executive succession and corporate dividend policies, social legal person shareholders have access

to corporate insider information and own the rights to question key executives‟ decisions

While tradable shares are usually held by investors who have small stakes, Xu (2004) identified a growing number of cases where a private blockholder was the dominant shareholder These investors have representatives on the board of directors and want to maximize corporate performance Compared to state shareholders or SOE investors, private blockholders can sell their shares more easily and often at the market value Moreover, private blockholders can trade their shares as collateral for personal loans, and a high share price increases the value of the collateral Therefore, private blockholders focus on both market value and high profitability of companies they invest in

In order to mitigate the excessive concentration of non-tradable shares

in listed companies, institutional environment in China shall be improved to allow more institutional investors to enter into the market and increase their long-term strategic investment so that different large shareholders could monitor each other Furthermore, institutional investors pool together funds of many individual investors, and take the position to protect the interests of them

2.3.2 A-shares, B-shares, and H-shares

According to the residency of shareholders, tradable shares of listed companies can be further classified into A-shares, B-shares and H-shares A-shares are equity stakes sold through IPOs to domestic investors and traded in the secondary market And they are denominated in RMB B-shares are issued

to foreign investors Originally, B-shares were only available to non-residents However, the B-share market has been opened to domestic individual investors since 2001 B-shares traded on the Shanghai Stock Exchange are

denominated in USD, and those traded on the Shenzhen Stock Exchange are denominated in Hong Kong dollars H-shares are issued to foreign investors trading on the Hong Kong Exchange and subject to stricter listing requirements Some Chinese firms go directly to overseas markets such as New York, London and Singapore to raise capital For example, N-shares are traded on U.S stock exchanges in the form of American Depository Receipts (ADRs) The majority of listed ADRs issued by Chinese companies are Level

I that are traded over-the-counter and not subject to the disclosure requirements of the SEC‟s Exchange Act In this study, these shares are all referred to as H-shares

Figure 3 Distribution of Foreign Shares in Chinese Listed Companies

Tradable B shares

Shares of Chinese listed companies owned by foreign investors have increased sharply after the adoption of a series of liberalization measures For example, in December 2002, the CSRC and the Peoples‟ Bank of China jointly issued Interim Measures on Managing Securities Investment of Qualified Foreign Institutional Investors, which allowed foreign institutional investors to invest in the A-share market Figure 3 demonstrates the distribution of both

tradable and non-tradable foreign shares in Chinese listed companies over the

1999 to 2008 period

2.4 Agency Conflict between Dominant Shareholders and Minority Shareholders

The institutional environment in China is unique in many aspects For

example, government agencies hold de facto ownership rights in SOEs but do

not bear any residual risks, the legal and regulatory frameworks are primitive with weak enforcement, and the corporate control market is very inactive Under such an environment, the most serious problems of corporate governance become insider control and the continuing expropriation of listed companies by their dominant shareholders through related-party transactions

2.4.1 Related-party transactions

Related-party transactions are one of the recurring areas of concern raised by recent corporate scandals, and they are commonly regarded as potential conflicts of interest that could compromise the management‟s agency responsibilities and the board of directors‟ monitoring effectiveness (Berle & Means, 1932; Jensen & Meckling, 1976) Related-party transactions could result in various negative consequences such as expropriation of corporate resources, low validity of corporate performance outcomes, and increased risks for external investors to make investment decisions Aside from the absolute amount, the decision of whether or not to engage in related-party transactions is an indicator of a firm‟s corporate governance environment As noted in a Wall Street Journal article on 7 May 2003:

“The dollar amounts of related-party transactions may be small, but

„each of these little things is a piece of mosaic and pretty soon they form a picture,‟ said Julie Fox Gorte, director of social research at

Carvert At Oracle, that picture is a company where the values of shareholders and executives aren‟t aligned.”

“Other investors aren‟t alarmed by the transactions because they are publicly disclosed, and the amount of money involved is relatively small, said Bhasin, the hedge fund analyst But most would prefer to see the practice end because of the risk that bad publicity over the deals could hurt a company‟s stock price.”

According to the Share Listing Rules stipulated by Shanghai Stock Exchange in 2004, related party transactions in listed companies are defined as transactions between a listed company and its controlled subsidiaries or other associated parties that could transfer corporate resources and responsibilities Here associated parties include a company‟s controlling shareholder, ultimate controller, directors, supervisors and senior executives However, SOEs are not considered as related parties only because they are all controlled by the state Related-party transactions with a total amount equal to or greater than RMB 1 million or 0.5 percent of a company‟s net assets must be reported to the stock exchanges within two working days after contract signing and be disclosed in its annual report Related-party transactions with a total amount equal to or greater than RMB 10 million or 5 percent of a company‟s net assets must obtain shareholders‟ approval at the shareholders‟ general meeting where related parties to the transaction cannot vote

Figure 4 shows that the number of related party transactions in companies listed on the Shanghai Stock Exchange increased sharply during the 2001 to 2005 period Regarding the industry distribution of related-party transactions, in 2005, 62 percent of related party transactions took place in the manufacturing industry, followed by the information and technology industry (7.5 percent) and the wholesale and retail trade industry (6.5 percent) Furthermore, 41 percent of related party transactions took place between listed

companies and other companies controlled by their parent organizations (Figure 5)

Figure 4 Related-party Transactions in Companies Listed on Shanghai Stock Exchange

Figure 5 Distribution of Related Parties of Shanghai-listed Companies involved in Related-party Transactions (2005)

Parent Company Controlling

shareholder

Subsidiaries Companies owned

by the same parent

2.4.2 Prevalence of fund misappropriation transactions initiated by dominant

shareholders

As one type of related party transactions, non-operating fund transfer between a listed company and its related parties can exhibit various forms such as cash misuse, insider trading, and off-balance-sheet transactions Fund misappropriation transactions have brought huge losses to small and medium-sized investors and corporate debt-holders

To prevent dominant shareholders from expropriating corporate funds for non-operating purposes, the CSRC, together with the State-owned Asset Supervision and Administration Commission, issued a Notice on Regulating the Fund between Listed Companies and Affiliates and Listed Companies‟ Provision of Guaranty for Other Parties (No 56[2003]) Specifically, five broad forms of non-operating fund transfer from a listed company to its dominant shareholder or other affiliates of the dominant shareholder are identified as fund misappropriation transactions: (1) pay expenses on labor, welfare, insurance, and advertisement on behalf of the dominant shareholder

or its affiliates; (2) repay a debt on behalf of the dominant shareholder or its affiliates; (3) provide the dominant shareholder or its affiliates with loans, either directly or indirectly, gratuitously or non gratuitously; (4) repay the loans resulting from bearing the liabilities of guaranty for the dominant shareholder or its affiliates; and (5) issue commercial acceptance bills to the dominant shareholder or its affiliates where no real transaction takes place

At the end of 2005, fund misappropriation initiated by dominant shareholders or other affiliates of the dominant shareholders existed in 407 of all the 1,377 domestically listed companies Table 3 displays the prevalence of fund misappropriation transactions initiated by dominant shareholders in all Shanghai-listed companies over the period 2001 – 2005 Figure 6 provides detailed information on the magnitude of fund misappropriation transactions initiated by the dominant shareholder in all Shanghai-listed companies over the sub-period 2003-2005