Berkman-Cole-Fu

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Political Connections and Minority-Shareholder
Protection Evidence from Securities-Market
Regulation in China

• Henk Berkman
• University of Auckland, Auckland, New Zealand
• Rebel A. Cole
• DePaul University, Chicago, USA
• Lawrence Fu
• Standard Chartered Bank, Beijing, PRC

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Summary

• In this study, we examine the wealth effects of
  three regulatory changes designed to improve
  minority-shareholder protection in China.
• We use the value of a firms related-party
  transactions as an inverse proxy for the quality
  of corporate governance at the firm.

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Summary

• We find that firms with weaker governance
  experienced significantly larger abnormal returns
  around announcements of the new regulations than
  did firms with stronger governance.
• This evidence indicates that securities-market
  regulation can be effective in protecting
  minority shareholders from expropriation in a
  country with weak judicial enforcement.

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Summary

• We also find that firms with strong ties to the
  government did not benefit from the new
  regulations.
• This evidence suggests that minority shareholders
  did not expect regulators to enforce the new
  rules on firms where block holders have strong
  political connections.

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Background Corporate Governance

• Share ownership confers two set of rights
• Cash-Flow Rights
• Control Rights
• How do owners of cash-flow rights ensure that
  they actually receive their pro-rata share of the
  firms cash flows?
• . . . How suppliers of finance to corporations
  ensure themselves of getting a return on their
  investment.
• Shleifer and Vishny (JF 1997)

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The Changing Focus of Corporate Governance

• Old focus solutions to principal-agent problems
  arising from the separation of ownership from
  control.
• How do we align interests of a firms managers
  with those of the firms shareholders?
• Research focused on firms located in the U.S.,
  where diffuse ownership (allegedly) is the norm.
• Jensen and Murphy (1990) Median CEO ownership of
  U.S. firms was only 0.25.
• Holderness (2008) most U.S. firms have large
  block holders.

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The Changing Focus of Corporate Governance

• 1990s Researchers became aware that, outside of
  the U.S. and Japan, dispersed ownership is the
  exception rather than the rule.
• Instead, ownership is concentrated in the hands
  of a few families or the State.
• Corporate Ownership Around the World,
• La Porta, Lopez de Silanes, Shleifer and Vishny
  (JF 1999)

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The Changing Focus of Corporate Governance

• When ownership is characterized by controlling
  shareholders, the focus of corporate governance
  shifts
• New focus Protection of the rights of minority
  shareholders.
• How to prevent controlling shareholder, rather
  than the firm manager, from expropriating the
  wealth of minority shareholders.

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The Changing Focus of Corporate Governance

• In general, the evidence in the law and finance
  literature suggests that countries with stronger
  legal protection enjoy greater financial
  development.
• Higher Stock Prices, more IPOs, larger stock
  markets, faster economic growth
• Implication Countries should try to improve the
  legal protection of minority shareholders

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The Changing Focus of Corporate Governance

• The law and finance literature distinguishes
  between legal protection and enforcement.
• You can have strong legal protection, but this is
  of little value without enforcement.

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The Changing Focus of Corporate Governance

• The law and finance literature also
  distinguishes between judicial enforcement and
  regulatory enforcement.
• Judicial enforcement is reactive. You have to sue
  in order to obtain relief.
• Regulatory enforcement is pro-active. No one need
  sue in order to obtain relief.
• This suggests that regulation can serve as a
  substitute for judicial enforcement, especially
  in emerging-market countries with weak
  judiciaries.
• Glaeser, Johnson and Shleifer (2001)

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Why Study China?

• At least 1.4 billion reasons . . . .
• Civil-law tradition with weak investor
  protection.
• Courts have been reluctant to protect minority
  investors.
• The State is usually the Controlling Shareholder
  but also is the Regulator.

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Key New Regulations2000 Q2 issued by the China
Securities Regulatory Commission (CSRC)

• 1. New regulations for annual shareholder
  meetings that improved the rights of minority
  shareholders and imposed fiduciary duties on
  directors.
• 2. Prohibition against issuance of debt
  guarantees to controlling shareholders
• 3. Limitations on and improved transparency for
  asset transfers between related parties.

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Hypotheses

• Effective regulations will result in positive
  market-wide abnormal returns around the
  announcements.
• Effective regulation will result in larger
  increases in value for minority shareholders of
  firms with poor governance (those that are more
  likely to be subject to expropriation by large
  block holders).
• Increases in value will be inversely related to
  the firms closeness to the State.

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Data

• Three sources
• Data on daily stock returns from Datastream
• Accounting data, ownership data and data on
  related-party transactions from GTA/CSMAR.
• Classification of largest shareholders from
  Delios et al. (2006)
• State Bureaucrats
• MOSOEs - Market Oriented SOEs
• Private Entities

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Data

• Proxy for quality of governance
• EXPROP the value of potentially harmful
  related-party transactions reported during 1999,
  scaled by market capitalization of the firm.

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Data

• Proxy for political connectedness
• degree of State ownership
• Chinese listed companies
• Most are only partially privatized
• The government maintains a controlling ownership
  position
• Typically, about 1/3 of shares are publicly
  traded (tradable shares).
• Remaining 2/3 of shares are non-tradable.
• (This has changed during last couple of years).

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Data

• Tradable shares no block holders by regulation
  (no one shareholdergt 0.5)
• Block holders of Non-Tradable shares
• Government entity (strongest connection)
• Government-controlled SOE (medium connection)
• Private entity (weakest connection)
• Non-tradable shares can be transferred, with
  consent of CSRC, but are highly illiquid.

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Methodology

• We estimate cumulative mean-adjusted market
  returns around the announcement of each
  regulation using the following model
• Market Return t ß0 ß1 Event 1 ß2
  Event 2 ß3 Event 3 e t
• Market Return t return on day t for an equally
  weighted portfolio consisting of our 887 sample
  firms (excludes firms listed in Hong Kong)
• Event windows one day before CSRC issuance of
  regulation through one day after first
  publication of reg.
• Estimation period 250 days before each event.
• ß J , J 1 to 3, cumulative mean-adjusted
  returns around each event
• Robustness test estimate market-adjusted
  returns, controlling for the return on a
  portfolio of 24 Chinese firms that trade (only)
  on the Hong Kong exchange.

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Market-Wide Price Reactions
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Market-Wide Price Reactions

• Test has limited power
• Long Event Windows
• High Market Volatility
• Regulations might not have affected . . .
• - firms with the strongest governance
• - firms with the strongest ties to the
  government
• . . . resulting in insignificant coefficients.

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More Powerful TestCross-Sectional Contrasts

• Firms with poor governance (high values of
  EXPROP) should benefit more than firms with good
  governance (low values of EXPROP), so we form a
  portfolio that is long on poor governance firms
  and short on good governance firms
• (EXPROP High t EXPROP Low t )
• ß0 ß1 Event 1 ß2 Event 2 ß3 Event
  3 ß4 Markett e t
• Where
• EXPROP High t return day t on a portfolio of
  highest tercile EXPROP
• EXPROP Low t return day t on a portfolio of
  lowest tercile EXPROP

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ResultsCross-Sectional Differences in EXPROP
(EXPROP High t EXPROP Low t )
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ResultsCross-Sectional Differences in EXPROP
(EXPROP High t EXPROP Low t ) Private Firms gt
MOSOEs gt State Bureaucrats
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Cross-Sectional DifferencesIndirect Measures of
Corporate Governance

• Largest shareholdings
• Larger shareholding reduces the wedge between
  control rights and cash flow rights ? less
  incentive to expropriate.
• Non-controlling block holders
• Larger non-controlling block holders ? better
  monitoring of controlling shareholder ? less
  expropriation.
• MOSOE/Private is largest block holder
• Increasingly more likely regulator will step in.
• Foreign Shareholders (B-shares)
• More likely to be institutional and aware of
  expropriation
• CEO is Chair
• Independent Directors.
• Firm Size and Leverage are included as control
  variables.

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Cross-Sectional DifferencesMultivariate
Methodology

• We could estimate a simple OLS regression model
• CARi, event J ß0 ß1,J Largest
  Shareholdingi
• ß2,J Non
  Controlling i
• ß3,J Private i
• .
• e iJ
• Problem cross-correlation in the firm return
  processes from which the CARs are estimated.
• Solution Sefcik and Thompson (1986) provide us
  with an alternative that gives unbiased estimates
  and standard errors that fully account for
  cross-sectional heteroscedasticity and
  cross-security dependence.

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Multivariate Cross-Sectional Analysis

• Orthogonalize all nine explanatory variables
• For each orthogonalized variable, construct a
  portfolio that is short firms in the lowest third
  and long firms in the highest third of the
  orthogonalized variables distribution.
• Regress the returns for each of the nine
  portfolios on the market return and a dummy
  variable (Events)
• R(OV-Hight) R(OV-Lowt)
• ß0 ß1 Events ß2 Market Returnt e t
• ß1 corresponds to cross-sectional parameter
  estimate from a regression of CARs on the
  explanatory variable.

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Contributions to the Literature

• First, we contribute to the literature on
  regulation as a substitute for judicial
  enforcement.
• We provide new evidence that securities-market
  regulation can be effective in protecting
  minority shareholders from expropriation in a
  country with weak judicial enforcement.

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Contributions to the Literature

• Second, we contribute to the literature on
  tunneling that analyzes related-party
  transactions between listed firms and their
  controlling block holders.
• We use the value of related-party transactions to
  calculate our proxy for the degree of
  expropriation by controlling block holders and
  provide evidence that regulations designed to
  protect minority shareholders disproportionately
  benefited firms with higher values of
  related-party transactions.

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Contributions to the Literature

• Third, we contribute to the literature on the
  importance of political connections.
• We provide new evidence that, in a country with a
  weak judicial system, such as China, investors
  are skeptical that regulators will enforce rules
  that would limit expropriation by controlling
  block holders with strong political connections.

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Contributions to the Literature

• Fourth, we contribute to the growing body of work
  on corporate governance in Chinaespecially the
  group of studies that have abandoned the
  official ownership scheme, which classifies
  owners of non-tradable shares primarily into two
  categories (State shares and legal-person
  shares) in favor of classifications based upon
  the identity of the ultimate owner (State shares,
  SOE shares and private shares).