Expropriation of Minority Investors in Chinese Listed Firms: The Role of Internal and External Corporate Governance Mechanisms

Abstract

Manuscript Type: Empirical Research Question/Issue: We investigate how ownership structure, board characteristics, and regional differences in law enforcement and stock market development affect the conflict of interest between majority and minority investors in Chinese listed firms. For this purpose, we study related‐party transactions as well as labor redundancy, and classify firms as either state‐ or private‐controlled. Research Findings/Insights: We find that related‐party transactions grow more extensive as the wedge between the controlling shareholder's control rights and cash flow rights increases. Related‐party transactions also rise with voting rights held by the government in state‐controlled firms. Next, the state as controlling shareholder exacerbates labor redundancy. The control rights of the second to tenth largest investors can offset expropriation. Regarding board characteristics, we find that a larger fraction of directors affiliated with the dominant owner enlarges related‐party transactions, while large boards also increase labor redundancy in state‐controlled firms. We find only weak evidence that higher‐quality institutions help to restrain expropriation of minority investors. Theoretical/Academic Implications: In Chinese listed firms, a major conflict of interest arises between majority and minority investors. Also, the state may exercise its control rights to achieve imperative social and political objectives, to the detriment of external investors. Yet, as the stock market valuation and financial performance of state‐controlled firms rise with the fraction of shares held by the state, future research should better delineate the conditions under which state ownership is either detrimental or beneficial to firms. Next, the results indicate that governance mechanisms suggested by conventional agency theory are deficient in Chinese listed firms. Future research could therefore establish more clearly when internal and external governance mechanisms are likely to work, thereby also taking into account the identity of the controlling shareholder. Practitioner/Policy Implications: Investors should be aware that expropriation in Chinese listed firms has specific implications when the state is the controlling owner. Also, at this stage of development, independent directors and external governance mechanisms can hardly protect the best interests of minority investors. Rather, expropriation is counterbalanced when voting rights are concentrated in the hands of other large block holders. Policy makers should work on ownership restructuring, board independence, and institutional quality to better protect minority rights in Chinese listed firms.

Empirical Research on Corporate Governance in China: A Review and New Directions for the Future

“…For example, Carney et al (2009) With respect to expropriation, there is evidence that state ownership relates negatively to intercorporate loans (Jiang et al, 2010), earnings management (Cheng et al, 2010;Ding et al, 2007), and financial fraud (Yuan, Yuan, & Deng, 2008), suggesting that the state is less likely to engage in expropriation. However, there is evidence that state ownership relates positively to related-party resource transfers/transactions (Huyghebaert & Wang, 2012;Shan, 2013) and financial fraud (Firth, Rui, & Wu, 2011;Hou & Moore, 2010). There are also studies that find state ownership to be unrelated to various indicators of expropriation such as fraud/earnings management (Ding et al, 2010;Liu & Lu, 2007), dividend payout , and auditor switching (Lin & Liu, 2009).…”

“…However, there is evidence suggesting that a high level of ownership concentration reduces the likelihood of a firm to provide misleading or fraudulent financial information to minority shareholders (Ding, Zhang, & Zhang, 2007;Hou & Moore, 2010;Liu & Lu, 2007). When expropriation is measured by less direct or less obvious indicators, such as related-party transactions or the price premium of nontradable share transfer, evidence is also mixed (Haveman & Wang, 2013;Huyghebaert & Wang, 2012;. Because indirect measures such as the above may not hurt the interests of minority shareholders (they can benefit minority shareholders when motivated by economic reasons), findings of this kind should be interpreted with caution.…”

“…Although some studies find board independence to relate positively to executive turnover (Firth et al, 2006b;Lau, Fan, Young, & Wu, 2007;You & Du, 2012) and negatively to expropriation (Shan, 2013), earnings management (Liu & Lu, 2007), and financial fraud (Chen et al, 2006), most studies find it to be insignificant in executive compensation Conyon & He, 2011Markoczy et al, 2013), strategic decisions (Chen & Cheng, 2007;Jia & Zhang, 2011;Li, Wright, & Scholes, 2010;Yeh et al, 2009), financial fraud (Ding et al, 2010;Firth et al, 2011;Huyghebaert & Wang, 2012;Jia et al, 2009), or firm performance (Du, 2013;Gang, 2007;Hu et al, 2010;Li & Naughton, 2007;Shen & Lin, 2009;Tian & Lau, 2001;Xu, Zeng, & Zhang, 2011).…”

“…For stock market-based performance measures, such as Tobin's q and shareholder returns, the findings are mixed. Although most studies report a negative association (Fan, Wong, & Zhang, 2007;Hovey, Li, & Naughton, 2003;Hu, Tam, & Tan, 2010;Huang & Zhao, 2008;Shan & McIver, 2011), there is evidence of a positive (Huyghebaert & Wang, 2012;Xu, Zeng, & Zhang, 2011), a U-shaped (Lin & Su, 2008), or an inverse U-shaped relation (Luo, Wan, Cai, & Liu, 2013). Given the consistent findings of a positive relation between ownership concentration and operational performance, the mixed findings on stock market-based performance are intriguing.…”

“…The evidence shows that the relation between ownership concentration and firm performance depends on the type of performance investigated. For operational performance, such as operational efficiency, profits, and ROA, studies generally report a positive relation (Deng & Wang, 2006;Du, 2013;Huyghebaert & Wang, 2012;Lu & Yao, 2006;You & Du, 2012). For example, after controlling for state ownership -another important feature of ownership structure in the listed firms -Wang, Guthrie, and find that ownership concentration has a strong positive relation with profitability, net profits, and operating margins, regardless of whether it is measured by the ownership of the largest top 3, top 5, or top 10 shareholders.…”