Berkman-Cole-Fu AFA 2009 Political Connections and Minority-Shareholder Protection: Evidence from...

Berkman-Cole-FuBerkman-Cole-FuAFA 2009AFA 2009

Political Connections Political Connections and and

Minority-Shareholder Protection: Minority-Shareholder Protection: Evidence from Securities-Market Regulation Evidence from Securities-Market Regulation

in Chinain China

Henk Berkman Henk Berkman

University of Auckland, Auckland, New Zealand University of Auckland, Auckland, New Zealand

Rebel A. Cole Rebel A. Cole

DePaul University, Chicago, USADePaul University, Chicago, USA

Lawrence Fu Lawrence Fu

Standard Chartered Bank, Beijing, PRCStandard Chartered Bank, Beijing, PRC


SummarySummary

In this study, we examine the wealth effects of In this study, we examine the wealth effects of three regulatory changes designed to improve three regulatory changes designed to improve minority-shareholder protection in China.minority-shareholder protection in China.

We use the value of a firm’s related-party We use the value of a firm’s related-party

transactions as an inverse proxy for the quality of transactions as an inverse proxy for the quality of corporate governance at the firm. corporate governance at the firm.


SummarySummary

We find that firms with weaker governance We find that firms with weaker governance experienced significantly larger abnormal returns experienced significantly larger abnormal returns around announcements of the new regulations around announcements of the new regulations than did firms with stronger governance.than did firms with stronger governance.

This evidence indicates that securities-market This evidence indicates that securities-market regulation can be effective in protecting minority regulation can be effective in protecting minority shareholders from expropriation in a country with shareholders from expropriation in a country with weak judicial enforcement. weak judicial enforcement.


SummarySummary

We also find that firms with strong ties to the We also find that firms with strong ties to the government did not benefit from the new government did not benefit from the new regulations. regulations.

This evidence suggests that minority This evidence suggests that minority shareholders did not expect regulators to enforce shareholders did not expect regulators to enforce the new rules on firms where block holders have the new rules on firms where block holders have strong political connections.strong political connections.


Background: Background: Corporate GovernanceCorporate Governance

Share ownership confers two set of rightsShare ownership confers two set of rights• Cash-Flow RightsCash-Flow Rights• Control RightsControl Rights

How do owners of cash-flow rights ensure that How do owners of cash-flow rights ensure that they actually receive their pro-rata share of the they actually receive their pro-rata share of the firm’s cash flows?firm’s cash flows?

““. . . How suppliers of finance to corporations . . . How suppliers of finance to corporations ensure themselves of getting a return on their ensure themselves of getting a return on their investment.”investment.”• Shleifer and Vishny (JF 1997)Shleifer and Vishny (JF 1997)


The Changing Focus The Changing Focus of Corporate Governanceof Corporate Governance

Old focus: solutions to principal-agent problems Old focus: solutions to principal-agent problems arising from the separation of ownership from arising from the separation of ownership from control.control.• How do we align interests of a firm’s managers How do we align interests of a firm’s managers

with those of the firm’s shareholders?with those of the firm’s shareholders?• Research focused on firms located in the U.S., Research focused on firms located in the U.S.,

where diffuse ownership (allegedly) is the where diffuse ownership (allegedly) is the norm.norm.

Jensen and Murphy (1990): Median CEO Jensen and Murphy (1990): Median CEO ownership of U.S. firms was only 0.25%.ownership of U.S. firms was only 0.25%.

Holderness (2008): most U.S. firms have Holderness (2008): most U.S. firms have large block holders.large block holders.



1990s: Researchers became aware that, outside 1990s: Researchers became aware that, outside of the U.S. and Japan, dispersed ownership is the of the U.S. and Japan, dispersed ownership is the exception rather than the rule.exception rather than the rule.

Instead, ownership is concentrated in the hands Instead, ownership is concentrated in the hands of a few families or the State.of a few families or the State.

““Corporate Ownership Around the World,”Corporate Ownership Around the World,”

La Porta, Lopez de Silanes, Shleifer and Vishny La Porta, Lopez de Silanes, Shleifer and Vishny (JF 1999)(JF 1999)



When ownership is characterized by controlling When ownership is characterized by controlling shareholders, the focus of corporate governance shareholders, the focus of corporate governance shifts:shifts:

New focus: Protection of the rights of minority New focus: Protection of the rights of minority shareholders.shareholders.

How to prevent controlling shareholder, rather How to prevent controlling shareholder, rather than the firm manager, from expropriating the than the firm manager, from expropriating the wealth of minority shareholders.wealth of minority shareholders.



In general, the evidence in the “law and finance” In general, the evidence in the “law and finance” literature suggests that countries with stronger literature suggests that countries with stronger legal protection enjoy greater financial legal protection enjoy greater financial development. development. • Higher Stock Prices, more IPOs, larger stock markets, Higher Stock Prices, more IPOs, larger stock markets,

faster economic growthfaster economic growth

Implication: Countries should try to improve the Implication: Countries should try to improve the legal protection of minority shareholderslegal protection of minority shareholders



The “law and finance” literature distinguishes The “law and finance” literature distinguishes between legal protection and enforcement.between legal protection and enforcement.

You can have strong legal protection, but this is You can have strong legal protection, but this is of little value without enforcement.of little value without enforcement.



The “law and finance” literature also The “law and finance” literature also distinguishes between judicial enforcement and distinguishes between judicial enforcement and regulatory enforcement.regulatory enforcement.• Judicial enforcement is reactive. You have to sue in order Judicial enforcement is reactive. You have to sue in order

to obtain relief.to obtain relief.• Regulatory enforcement is pro-active. No one need sue Regulatory enforcement is pro-active. No one need sue

in order to obtain relief.in order to obtain relief. This suggests that regulation can serve as a This suggests that regulation can serve as a

substitute for judicial enforcement, especially in substitute for judicial enforcement, especially in emerging-market countries with weak judiciaries.emerging-market countries with weak judiciaries.

[Glaeser, Johnson and Shleifer (2001)][Glaeser, Johnson and Shleifer (2001)]


Why Study China?Why Study China?

At least 1.4 billion reasons . . . .At least 1.4 billion reasons . . . .

Civil-law tradition with weak investor protection.Civil-law tradition with weak investor protection.

Courts have been reluctant to protect minority Courts have been reluctant to protect minority investors.investors.

The State is usually the Controlling Shareholder The State is usually the Controlling Shareholder but also is the Regulator.but also is the Regulator.


Key New Regulations—2000 Q2 Key New Regulations—2000 Q2 issued by the issued by the

China Securities Regulatory Commission China Securities Regulatory Commission (“CSRC”)(“CSRC”)

1. 1. New regulations for annual shareholder meetings New regulations for annual shareholder meetings that improved the rights of minority shareholders that improved the rights of minority shareholders and imposed fiduciary duties on directors.and imposed fiduciary duties on directors.

2. Prohibition against issuance of debt guarantees to 2. Prohibition against issuance of debt guarantees to controlling shareholderscontrolling shareholders

3. Limitations on and improved transparency for asset 3. Limitations on and improved transparency for asset transfers between related parties.transfers between related parties.


HypothesesHypotheses

Effective regulations will result in positive market-Effective regulations will result in positive market-wide abnormal returns around the wide abnormal returns around the announcements.announcements.

Effective regulation will result in larger increases Effective regulation will result in larger increases in value for minority shareholders of firms with in value for minority shareholders of firms with poor governance (those that are more likely to be poor governance (those that are more likely to be subject to expropriation by large block holders).subject to expropriation by large block holders).

Increases in value will be inversely related to the Increases in value will be inversely related to the firm’s closeness to the State.firm’s closeness to the State.


DataData

Three sources:Three sources:• Data on daily stock returns from Datastream Data on daily stock returns from Datastream

• Accounting data, ownership data and data on related-Accounting data, ownership data and data on related-party transactions from GTA/CSMAR.party transactions from GTA/CSMAR.

• Classification of largest shareholders from Delios Classification of largest shareholders from Delios et al. et al. (2006) (2006)

State BureaucratsState Bureaucrats MOSOEs - Market Oriented SOEsMOSOEs - Market Oriented SOEs Private EntitiesPrivate Entities


DataData

Proxy for quality of governance:Proxy for quality of governance: • EXPROP: the value of potentially harmful EXPROP: the value of potentially harmful

related-party transactions reported during related-party transactions reported during 1999, scaled by market capitalization of the 1999, scaled by market capitalization of the firm.firm.


DataData

Proxy for “political connectedness”: Proxy for “political connectedness”: • degree of State ownershipdegree of State ownership

Chinese listed companies: Chinese listed companies: • Most are only “partially privatized”Most are only “partially privatized”• The government maintains a controlling The government maintains a controlling

ownership positionownership position• Typically, about 1/3 of shares are publicly Typically, about 1/3 of shares are publicly

traded (“tradable shares”).traded (“tradable shares”).• Remaining 2/3 of shares are “non-tradable.”Remaining 2/3 of shares are “non-tradable.”• (This has changed during last couple of years).(This has changed during last couple of years).


DataData

Tradable shares: no block holders by regulation Tradable shares: no block holders by regulation (no one shareholder> 0.5%)(no one shareholder> 0.5%)

Block holders of Non-Tradable shares:Block holders of Non-Tradable shares:• Government entity (strongest connection)Government entity (strongest connection)• Government-controlled SOE (medium Government-controlled SOE (medium

connection)connection)• Private entity (weakest connection)Private entity (weakest connection)

Non-tradable shares can be transferred, with Non-tradable shares can be transferred, with consent of CSRC, but are highly illiquid.consent of CSRC, but are highly illiquid.


MethodologyMethodology

We estimate cumulative We estimate cumulative mean-adjustedmean-adjusted market returns around the market returns around the announcement of each regulation using the following model:announcement of each regulation using the following model:

Market Return Market Return tt = β = β00 + β + β11 Event 1 + β Event 1 + β2 2 Event 2 + β Event 2 + β33 Event 3 + ε Event 3 + ε tt

• Market Return Market Return tt: return on day t for an equally weighted portfolio : return on day t for an equally weighted portfolio consisting of our 887 sample firms (excludes firms listed in Hong consisting of our 887 sample firms (excludes firms listed in Hong Kong)Kong)

• Event windows: Event windows: one day before CSRC issuance of regulation through one day before CSRC issuance of regulation through one day after first publication of reg.one day after first publication of reg.

• Estimation period: 250 days before each event.Estimation period: 250 days before each event.• ββ J J , J = 1 to 3, cumulative mean-adjusted returns around each event , J = 1 to 3, cumulative mean-adjusted returns around each event

Robustness test: estimate Robustness test: estimate marketmarket-adjusted-adjusted returns returns, controlling for the , controlling for the return on a portfolio of 24 Chinese firms that trade (only) on the Hong return on a portfolio of 24 Chinese firms that trade (only) on the Hong Kong exchange.Kong exchange.


Market-Wide Price ReactionsMarket-Wide Price Reactions

Long Event Windows

5-Day Event Windows

Variable Model (1) Model (2) Model (1) Model (2) Intercept

0.002 (1.6)

0.001 (1.4)

0.002 (1.5)

0.001 (1.4)

Event 1: Shareholder Meeting

0.101 b (2.1)

0.117 b (2.3)

0.099 b (2.1)

0.107 b (2.3)

Event 2: Related Guarantees

0.011 (0.2)

0.001 (0.0)

0.011 (0.2)

-0.001 -(0.0)

Event 3: Asset Transfer

0.019 (0.3)

0.006 (0.1)

0.023 (0.5)

0.011 (0.3)

Hong Kong Return

0.086 b (2.0)

0.079 c (1.9)


Market-Wide Price ReactionsMarket-Wide Price Reactions

Test has limited power:Test has limited power:

1.1. Long Event WindowsLong Event Windows

2.2. High Market VolatilityHigh Market Volatility

3.3. Regulations might not have affected . . . Regulations might not have affected . . .

- firms with the strongest governance - firms with the strongest governance

- firms with the strongest ties to the government- firms with the strongest ties to the government

. . . resulting in insignificant coefficients.. . . resulting in insignificant coefficients.


More Powerful Test:More Powerful Test:Cross-Sectional Contrasts Cross-Sectional Contrasts

Firms with poor governance (high values of EXPROP) Firms with poor governance (high values of EXPROP) should benefit more than firms with good governance should benefit more than firms with good governance (low values of EXPROP), so we form a portfolio that is (low values of EXPROP), so we form a portfolio that is long on poor governance firms and short on good long on poor governance firms and short on good governance firms:governance firms:

(EXPROP (EXPROP High High t t – – EXPROP EXPROP Low Low tt ) = ) =

ββ00 + β + β11* Event 1 + β* Event 1 + β2 2 * Event 2 + β* Event 2 + β3 3 * Event 3 + β* Event 3 + β4 4 * Market* Markettt + ε + ε t t

Where:Where:

EXPROP EXPROP High High tt = = return day return day tt on a portfolio of on a portfolio of highesthighest tercile EXPROP tercile EXPROP

EXPROP EXPROP Low Low tt = = return day return day tt on a portfolio of on a portfolio of lowestlowest tercile EXPROP tercile EXPROP


Results:Results:Cross-Sectional Differences in EXPROPCross-Sectional Differences in EXPROP

(EXPROP (EXPROP High High t t – – EXPROP EXPROP Low Low tt ) )

(1)

EventsPanel A: All Firms

Long Event Windows 0.035 a 0.018 c 0.052 a 0.101 a

(2.9) (1.7) (3.0) (4.1)

Five-Day Event Windows 0.026 b 0.016 0.024 b 0.065 a

(2.2) (1.5) (2.1) (3.2)

Meeting Guarantees Transfers

Shareholder Related Asset All Three

(2) (3) (4) (5)


Results:Results:Cross-Sectional Differences in EXPROPCross-Sectional Differences in EXPROP

(EXPROP (EXPROP High High t t – – EXPROP EXPROP Low Low tt ) ) Private Firms > MOSOEs > State BureaucratsPrivate Firms > MOSOEs > State Bureaucrats

State 0.003 0.010 0.003 0.015Bureaucrats (0.2) (0.7) (0.2) (0.6)

MOSOEs 0.039 b 0.023 0.052 b 0.110 a(2.4) (1.5) (2.3) (3.3)

Private 0.065 b 0.048 b 0.074 b 0.182 aEntities (2.5) (2.0) (2.0) (3.4)

EventsAll Three

Meeting Guarantees TransfersShareholder Related Asset


Cross-Sectional Differences:Cross-Sectional Differences:Indirect Measures of Corporate GovernanceIndirect Measures of Corporate Governance

Largest shareholdings: Largest shareholdings: Larger shareholding reduces the wedge between control rights Larger shareholding reduces the wedge between control rights and cash flow rights and cash flow rights →→ less incentive to expropriate. less incentive to expropriate.

Non-controlling block holders:Non-controlling block holders:

Larger non-controlling block holders Larger non-controlling block holders →→ better monitoring of better monitoring of controlling shareholder controlling shareholder → → less expropriation.less expropriation.

MOSOE/Private is largest block holder:MOSOE/Private is largest block holder: Increasingly more likely regulator will step in.Increasingly more likely regulator will step in.

Foreign Shareholders (B-shares):Foreign Shareholders (B-shares): More likely to be institutional and aware of expropriationMore likely to be institutional and aware of expropriation

CEO is ChairCEO is Chair Independent Directors.Independent Directors. Firm Size and LeverageFirm Size and Leverage are included as control variables. are included as control variables.


Cross-Sectional Differences:Cross-Sectional Differences:Multivariate MethodologyMultivariate Methodology

We We couldcould estimate a simple OLS regression model: estimate a simple OLS regression model:

CARCARi, event J i, event J = = ββ00 + + ββ1,J1,J * Largest Shareholding* Largest Shareholding ii + + ββ2,J2,J * Non Controlling * Non Controlling ii

+ + ββ3,J3,J * Private * Private ii + + ………. ……….

+ + εε iJ iJ Problem: cross-correlation in the firm return processes Problem: cross-correlation in the firm return processes

from which the CARs are estimated. from which the CARs are estimated. Solution: Sefcik and Thompson (1986) provide us with Solution: Sefcik and Thompson (1986) provide us with

an alternative that gives unbiased estimates and an alternative that gives unbiased estimates and standard errors that fully account for cross-sectional standard errors that fully account for cross-sectional heteroscedasticity and cross-security dependence.heteroscedasticity and cross-security dependence.


Multivariate Cross-Sectional AnalysisMultivariate Cross-Sectional Analysis

1.1. Orthogonalize all nine explanatory variables Orthogonalize all nine explanatory variables 2.2. For each orthogonalized variable, construct a portfolio For each orthogonalized variable, construct a portfolio

that is short firms in the lowest third and long firms in that is short firms in the lowest third and long firms in the highest third of the orthogonalized variable’s the highest third of the orthogonalized variable’s distribution. distribution.

3.3. Regress the returns for each of the nine portfolios on Regress the returns for each of the nine portfolios on the market return and a dummy variable (the market return and a dummy variable (Events)Events)::

R(OV-HighR(OV-Hightt) – R(OV-Low) – R(OV-Lowtt)) = =

ββ00 + + ββ1 1 Events Events + + ββ22 Market ReturnMarket Returnt t + + ε ε tt

ββ11 corresponds to cross-sectional parameter estimate corresponds to cross-sectional parameter estimate from a regression of CARs on the explanatory variable.from a regression of CARs on the explanatory variable.


Cash-Flow Rights > 30% -0.046 a -0.027 c 0.003

-(3.1) -(1.8) (0.2)

Non-Controlling Block holders-0.057 a -0.059 a -0.052 b

-(3.2) -(2.8) -(2.2)MOSOE 0.011 0.011 -0.014

(0.9) (0.7) -(0.8)

Private Entity 0.047 a 0.047 a 0.05 a

(3.2) (3.2) (2.6)

B-shares -0.069 a -0.086 a -0.101 a

-(3.5) -(3.5) -(3.3)

CEO is Chair 0.032 a 0.030 c -0.001

(2.6) (1.7) -(0.0)

Independent Directors -0.043 b -0.055 b -0.054 b

-(2.6) -(2.5) -(2.5)Leverage -0.023 -0.028 -0.033

-(1.4) -(1.3) -(1.2)

Total Assets (log) 0.093 a 0.129 a 0.15 a

(4.2) (4.3) (4.4)

High vs. Low Half

High vs. Low Third

High vs. Low Fifth

Sefcik and Thompson Cross-Sectional Results


Contributions to the LiteratureContributions to the Literature

First, we contribute to the literature on regulation First, we contribute to the literature on regulation as a substitute for judicial enforcement. as a substitute for judicial enforcement.

We provide new evidence that securities-market We provide new evidence that securities-market regulation can be effective in protecting minority regulation can be effective in protecting minority shareholders from expropriation in a country with shareholders from expropriation in a country with weak judicial enforcement. weak judicial enforcement.



Second, we contribute to the literature on Second, we contribute to the literature on “tunneling” that analyzes related-party “tunneling” that analyzes related-party transactions between listed firms and their transactions between listed firms and their controlling block holders.controlling block holders.

We use the value of related-party transactions to We use the value of related-party transactions to calculate our proxy for the degree of calculate our proxy for the degree of expropriation by controlling block holders and expropriation by controlling block holders and provide evidence that regulations designed to provide evidence that regulations designed to protect minority shareholders disproportionately protect minority shareholders disproportionately benefited firms with higher values of related-benefited firms with higher values of related-party transactions. party transactions.



Third, we contribute to the literature on the Third, we contribute to the literature on the importance of political connections.importance of political connections.

We provide new evidence that, in a country with We provide new evidence that, in a country with a weak judicial system, such as China, investors a weak judicial system, such as China, investors are skeptical that regulators will enforce rules are skeptical that regulators will enforce rules that would limit expropriation by controlling block that would limit expropriation by controlling block holders with strong political connections. holders with strong political connections.



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

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