Can Internal Governance Mechanisms Prevent Asset Appropriation? Examination of Type I Tunneling in China

• Date: 01 May 2013
• Published date: 01 May 2013
• Author: Yuan George Shan
• DOI: http://doi.org/10.1111/corg.12022

Can Internal Governance Mechanisms Prevent

Asset Appropriation? Examination of Type I

Tunneling in China

Yuan George Shan*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Direct transfer (Type I tunneling) means that the controlling shareholders transfer resources from

the f‌irm for their own benef‌it. This study aims to investigate the impact of internal and external governance mechanisms

from the perspective of principal-principal (P-P) conf‌licts on Type I tunneling.

Research Findings/Insights: Using hand-collected data comprising 117 Chinese listed companies with 540 f‌irm-year

observations during 2001–2005, the results show that state ownership and the number of board of directors’ meetings are

positively correlated with Type I tunneling, whereas the number of independent directors reveals a negative association.

Other internal governance mechanisms including foreign ownership, the size of the board of directors, supervisory board

size, number of professional supervisors, and the number of supervisory board meetings were found to have no impact.

Theoretical/Academic Implications: Several implications can be drawn. First, this study has modeled tunneling using a

well-accepted theoretical perspective – agency theory of P-P conf‌licts. But the results show that agency theory does not

appropriately explain tunneling behavior in China and so institutional theory is suggested as an alternative theoretical

perspective for future research. Second, corporate governance reforms relating to supervisory boards have not been

suff‌icient to ensure that they properly fulf‌ill their role of oversight. Rather, such supervisory boards are perhaps playing

more of a “rubber stamp” role.

Practitioner/Policy Implications: This study recommends prescribing the legal responsibilities and obligations for two-tier

boards in the Chinese context, allowing them to undertake their duties diligently.

Keywords: Corporate Governance, China, Type I Tunneling

INTRODUCTION

Traditionally, the research on corporate governance

focuses on conf‌licts of interests between owners and

management from the principal-agent (P-A) perspective.

The P-A problem results from a divergence of interests

between owners and managers that causes the managers to

fail to maximize the welfare of the owners (Denis &

McConnell, 2003; Jensen & Meckling, 1976; Johnson, La

Porta, Lopez-de-Silanes, & Shleifer, 2000; Shleifer & Vishny,

1997). Such conf‌licts can be moderated by improving two

kinds of corporate governance mechanisms. These include

internal governancemechanisms (IGMs), such as ownership

structure, board of directors, and supervisory board, and

external governance mechanisms (EGMs), such as corporate

control, legal environment, and market development

(Demsetz & Lehn, 1985; Denis & McConnell, 2003; Fama &

Jensen, 1983). The literature applies this concept in many

corporate governance studies in developed economies.

Because company ownership in the emerging economies is

highly concentrated, this concept is less signif‌icant. Instead

of the traditional P-A problem, Dharwadkar, George, and

Brandes (2000) and Young, Peng, Ahlstrom, Bruton, and

Jiang (2008) suggest that the principal-principal (P-P)

problem becomes a major concern for corporate governance

in emerging economies that are characterized by high own-

ership concentration, extensive family ownership and

control, and weak legal protection of minority shareholders.

P-P conf‌licts of interests between controlling shareholders

and minority shareholders often result in asset appropria-

tion which is referred to as tunneling (Shleifer & Vishny,

1997).

*Address for correspondence: YuanGeorge Shan, The University ofAdelaide Business

School, 10 Pulteney Street,Adelaide, SA 5005, Australia. Tel: 61 8 83136456; Fax: 61 8

82234782; E-mail: george.shan@adelaide.edu.au

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Corporate Governance: An International Review, 2013, 21(3): 225–241

© 2013 Blackwell Publishing Ltd

doi:10.1111/corg.12022

Tunneling is used to describe the transfer of resources out

of f‌irms for the benef‌it of controlling shareholders. It can

occur in two forms: direct transfer (Type I tunneling) and

indirect transfer (Type II tunneling) (Johnson et al., 2000). In

Type I tunneling, the controlling shareholders simply trans-

fer resources out of the f‌irm for their own benef‌it. It includes

theft or fraud, and asset sales and contracts, i.e. advantages

of transfer pricing for the controlling shareholder, excessive

executive compensation, loan guarantees, and expropriation

of corporate opportunities. Type II tunneling is more diff‌i-

cult to observe than Type I tunneling. The controlling share-

holders can increase their share through dilutive share

issues, minority freeze-outs, insider trading, creeping acqui-

sitions, or other f‌inancial transactions that embezzle the

interests of minority shareholders (Johnson et al., 2000).

The literature distinguishes between Type I and Type II

tunneling. Prior studies use the Type I tunneling method to

provide evidence on tunneling or propping1by controlling

shareholders, and most of these studies focus on developing

economies (Bae, Kang, & Kim, 2002; Berkman, Cole, & Fu,

2009; Bertrand, Mehta, & Mullainathan, 2002; Cheung, Rau,

& Stouraitis, 2006). For example, in a study of South Korean

stock market reactions to merger announcements, Bae et al.

(2002) f‌ind that controlling shareholders use intra-group

acquisitions to expropriate the interests of minority share-

holders. In India, Bertrand et al. (2002) use an innovative

technique for tunneling analysis and f‌ind evidence of wealth

expropriation from minority shareholders by controlling

shareholders to divert cash f‌lows from f‌irms in which they

have low cash-f‌low rights to f‌irms in which they have high

cash-f‌low rights. Cheung et al. (2006) examine connected

transactions between Hong Kong listed companies and their

controlling shareholders and f‌ind that minority sharehold-

ers experience signif‌icant value losses when companies

undertake connected transactions.

However, other studies adopt the indirect transferring

method to examine Type II tunneling and proxies for f‌irm

value and f‌inancial performance (Claessens, Djankov, Fan, &

Lang, 2002; Doidge, Karolyi, & Stulz, 2004, 2009; Joh, 2003;

Klapper & Love, 2004; La Porta, Lopez-de-Silanes, Shleifer,

& Vishny, 2000, 2002; Lins, 2003). For example, La Porta et al.

(2000) provide an international study of 33 countries and

f‌ind that f‌irms in countries with better protection of minor-

ity shareholders pay higher dividends. Using data from 27

wealthy countries, La Porta et al. (2002) examine the asso-

ciation between investor protection and f‌irm value and f‌ind

that f‌irms in countries with better investor protection have

signif‌icantly higher values. Claessens et al. (2002) provide a

study of eight East Asian countries and f‌ind that Tobin’s Q

decreases with the separation of cash-f‌low rights from the

control rights of the largest blockholder. In an examination

of the differences in the value of cross-listed foreign compa-

nies, Doidge et al. (2004) f‌ind that cross-listed companies

have signif‌icantly higher valuations. Doidge et al. (2009) also

f‌ind that the likelihood of a company’s decision for cross-

listing on a US stock exchange reveals an inverse association

with the control rights and cash-f‌low rights held by the

controlling shareholder.

Type II tunneling such as minority freeze-outs and share

dilution are less relevant in emerging economies because the

state usually acts as a dominant shareholder to erode the

delisting mechanism and manipulate share dilution (Gao &

Kling, 2008a, 2008b), thus distortion of results will be

incurred if these proxies are used. However, Type I tunnel-

ing is more relevant as most asset appropriation was con-

ducted through related party transactions (Cheung et al.,

2006; Gao & Kling, 2008a).

Young et al. (2008) recommend that future studies could

address P-P conf‌licts in emerging economies by learning

from experience in terms of ownership concentration in

developed economies. P-P conf‌licts are characterized by

concentrated ownership with indicators of poor governance

including asset appropriation or tunneling of minority

shareholders (Claessens, Djankov, & Lang, 2000; Johnson et

al., 2000). Resolving P-P conf‌licts in emerging economies

could improve the living standards for potentially millions

of people (Morck, Wolfenzon, & Yeung, 2005). The objective

of this study is to examine whether IGMs prevent Type I

tunneling from the perspective of P-P conf‌licts of interests

between the controlling shareholders and the minority

shareholders in emerging economies. As China has recently

suffered signif‌icant asset appropriation (Cheung, Jing, Lu,

Rau, & Stouraitis, 2009; Gao & Kling, 2008a; Liu & Lu, 2007),

this paper takes China as a case study and provides empiri-

cal evidence of the impact of IGMs and EGMs on Type I

tunneling during the important period of regulatory reform

between 2001 and 2005. These IGMs represent the unique

characteristics of the Chinese corporate governance system;

in particular, this study intends to shed light on the impact

of the supervisory board, an important yet unexplored cor-

porate governance element, on Type I tunneling. The

primary results show that state ownership and the number

of board of directors’ meetings are positivelycorrelated with

Type I tunneling, whereas the number of independent direc-

tors reveals a negative association. Other IGMs including

foreign ownership, the size of the board of directors, super-

visory board size, the number of professional supervisors,

and the number of supervisory board meetings were found

to have no impact. This study also tests the robustness of the

primary results by examining IGMs on each share type (i.e.

A-share, AB-share and AH-share). An interesting f‌inding is

that foreign ownership shows a negative correlation with

Type I tunneling in AB-share companies.

This paper contributes to the current literature in f‌ive

ways. First, taking China as a case study, this work builds on

the foundation of Young et al. (2008) to test the crucial P-P

conf‌licts between controlling shareholders and minority

shareholders, and provides evidence indicating that concen-

trated state ownership expropriates the interests of minority

shareholders. However, the results are weak and provide

little support for agency theory explanations of P-P conf‌licts.

Thus, institutional theory might be a more promising expla-

nation for Type I tunneling as it has become the predomi-

nant theory for corporate governance research in emerging

economies (Hoskisson, Eden, Lau, & Wright, 2000; Lin &

Chuang, 2011; Wright, Filatotchev, Hoskisson, & Peng,

2005).

Second, China has attempted to incorporate both the

German and Anglo-American board structures to form its

IGMs with a unique setting – board of directors and super-

visory board (Shan & Round, 2012). Few studies have inves-

tigated tunneling by controlling shareholders using these

226 CORPORATE GOVERNANCE

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