Controlling Shareholder‐Manager Collusion and Tunneling: Evidence from China

• Date: 01 November 2014
• Published date: 01 November 2014
• DOI: http://doi.org/10.1111/corg.12081
• Author: Fuxiu Jiang,Min Zhang,Shenghao Gao,Xinjiao Guan

Controlling Shareholder-Manager Collusion and

Tunneling: Evidence from China

Min Zhang*, Shenghao Gao, Xinjiao Guan, and Fuxiu Jiang

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines whether and how controlling shareholders collude with managers with

respect to tunneling.

Research Findings/Insights: Using data from Chinese listed companies, we f‌ind evidence consistent with the collusion

hypothesis. Specif‌ically, we f‌ind that the separation of control and cash f‌low rights is negatively associated with managerial

pay-performance and turnover-performance sensitivity. These results suggest that controlling shareholders with excess

control rights collude with managers by weakening performance-based incentives. Further evidence suggests that the

negative relation between excesscontrol rights and performance-based incentives is more pronounced in less prof‌itable and

less promising f‌irms. We also f‌ind preliminary evidence for rent-sharing behavior between controlling shareholders and

managers.

Theoretic/Academic Implications: We incorporate the inf‌luence of managers into the agency framework between control-

ling and minority shareholders and suggest that controlling shareholders and managers expropriate the minority share-

holders. We also propose that excess control rights undermine normal, effective, performance-based incentives and induce

rent-sharing behavior between controlling shareholders and managers.

Practitioner/Policy Implications: We advise f‌irms’ stakeholders, especially minority shareholders, to detect tunneling by

observing executive incentives. We suggest that policy makers pay particular attention to the collusion between tunneling

participants rather than merely prohibiting certain tunneling tactics. We also recommend that regulators strengthen corpo-

rate governance norms and improve the corporate governance environment.

Keywords: Corporate Governance, Collusion, Performance-Based Incentives, Separation of Control and Cash Flow

Rights, Tunneling

INTRODUCTION

Recent literature documents the prevalence of control-

ling shareholders in modern corporations (La Porta,

Lopez-de-Silanes, & Shleifer, 1999). Through mechanisms

such as pyramids, cross-shareholdings, and multiple-class

shares,1controlling shareholders achieve control rights in

excess of their cash f‌low rights (Claessens, Djankov, & Lang,

2000; Faccio & Lang, 2002; La Porta et al., 1999). These excess

control rights2induce controlling shareholders to engage in

various forms of tunneling, including grabbing opportuni-

ties, transferring assets, and enforcing loan guarantees

(Claessens, Djankov, Fan, & Lang, 2002; Fan & Wong, 2002;

Johnson, La Porta, Lopez-de-Silanes, & Shleifer, 2000).

However, tunneling cannot be realized without the

support of managers. As corporate insiders, managers have

superior access to private information, make corporate deci-

sions, and are eventually responsible for corporate out-

comes. Nevertheless, studies generally ignore the impact of

managers on tunneling. The implicit assumption is that

managers always act in the interests of the controlling share-

holders with respect to tunneling.

However, this implicit assumption applies only when the

controlling shareholders and managers have homogeneous

utilities in terms of tunneling. Unlike controlling sharehold-

ers, managers suffer risks and costs but gain few benef‌its

from tunneling. Specif‌ically, tunneling brings noise into cor-

porate operations and corporate outcomes. Thus, f‌irm per-

formance becomes a noisy outcome that cannot impartially

ref‌lect the managers’ decisions and efforts (Wang & Xiao,

2011). Therefore, managers suffer potential risks when

their pay and possible dismissal f‌luctuate with such noisy

*Address for correspondence: Min Zhang, School of Business, Renmin University of

China, No.59, Zhongguancun Street, Haidian District, Beijing, 100872, China. Tel: +

8610 8250 0403; Fax: +8610 8250 9169; E-mail: minzhang@ruc.edu.cn

440

Corporate Governance: An International Review, 2014, 22(6): 440–459

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12081

performance. More importantly, tunneling often shrinks a

f‌irm’s performance and equity value (Claessens et al., 2002;

Lemmon & Lins, 2003). Accordingly, managers bear mon-

etary losses and diminishing returns on human capital when

they are paid or dismissed for such reduced performance.

Even worse, managers benef‌it little from tunneling. Almost

all of the private benef‌its accrue to the controlling sharehold-

ers rather than the managers.Apparently, the costs that man-

agers bear outweigh the benef‌its they reap. It follows that

rational, risk-averse managers would prefer to resist tunnel-

ing. Hence, a few questions naturally arise. Do managers

resist tunneling? If so, why does tunneling still take place in

practice? If not, why do managers accept tunneling after

weighing its benef‌its and costs?

A potential answer to the aforementioned questions is

that controlling shareholders collude with managers with

respect to tunneling. Controlling shareholders with excess

control rights have both the ability and the incentive to

collude with managers. On the one hand, control rights

endow the controlling shareholders with absolute control

over f‌irms. Often, controlling shareholders can nominate

board members (Cullinan, Wang, Wang, & Zhang, 2012) and

determine managers’ remunerations, appointments, and

dismissals (Conyon & He, 2011; Firth, Fung, & Rui, 2006a).

On the other hand, separated cash f‌low rights provide con-

trolling shareholders strong incentives to divert f‌irm

resources, and such tunneling incentives are stronger as

control–ownership divergence increases (Claessens et al.,

2002; Fan & Wong, 2002; Lin, Ma, Malatesta, & Xuan, 2013).

To explore the possible collusive relationship between

controlling shareholders and managers, we f‌irst investigate

whether controlling shareholders with excess control rights

are likely to weaken performance-based incentives. Diluting

performance-based incentives adds to the payoff of control-

ling shareholders, ceteris paribus, because doing so shields

managers from potential risks and costs, reduces the resis-

tance from managers, and facilitates tunneling. Therefore,

controlling shareholders with excess control rights tend to

weaken performance-based incentives. These consider-

ations posit a negative relation between excess control

rights and performance-based incentives and suggest a col-

lusive relationship between controlling shareholders and

managers. Nevertheless, in a dynamic world, controlling

shareholders experience a disutility from weakening

performance-based incentives. Because managers’ utilities

are less dependent on performance, managers are less moti-

vated to create prof‌its; consequently, the resources available

for future tunneling are reduced. Taking this disutility into

consideration, controlling shareholders are unwilling to

weaken performance-based incentives. Therefore, there

should be a nonnegative relation between excess control

rights and performance-based incentives. As a consequence,

controlling shareholders with excess control rights would

trade off the benef‌its and costs in weakening performance-

based incentives. It follows that the overall effect of excess

control rights on performance-based incentives is an empiri-

cal question.

Using data from Chinese listed companies, we f‌ind evi-

dence consistent with the collusion hypothesis. Specif‌ically,

we f‌ind that the separation of control and cash f‌low rights is

negatively associated with managerial pay-performance and

turnover-performance sensitivity. These negative relations,

which are robust to alternative model specif‌ications and

variable measurements, suggest that controlling sharehold-

ers collude with managers by weakening normal, effective

performance-based incentives.

We further test the collusion hypothesis by considering

f‌irm heterogeneity. Specif‌ically, we investigate whether the

strength of collusion varies with certain f‌irm characteristics.

We f‌ind that the negative relation between excess control

rights and performance-based incentives is more pro-

nounced in less prof‌itable and less promising f‌irms. These

results suggest that the strength of collusion increases in

f‌irms for which it is less costly for the controlling sharehold-

ers to weaken performance-based incentives.

Finally, we f‌ind preliminary evidence for rent-sharing

behavior between controlling shareholders and managers.

Specif‌ically, we f‌ind that the separation of control and cash

f‌low rights is positively associatedwith managerial compen-

sation and perks. These results suggest that, apart from

weakening performance-based incentives, controlling

shareholders with excess control rights also share rents with

managers by offering higher compensation and providing

more perks.

We contribute to the literature in several ways. First, we

incorporate the inf‌luence of managers into the agency

framework between controlling and minority shareholders

and suggest that controlling shareholders, along with man-

agers, expropriate the minority shareholders. The literature

in this f‌ield generally overlooks the impact of managers on

tunneling. Two possible exceptions are Burkart, Panunzi,

and Shleifer (2003) and Wang and Xiao (2011). Burkart et al.

(2003) introduce a collusion factor into the theoretical model

and propose that the collusion in family f‌irms between

founders and managers reduces monitoring. Our study

echoes Burkart et al. (2003) by providing evidence for the

collusion between managers and controlling shareholders

but not founders and supports the authors’ proposition that

collusion reduces monitoring. Our f‌indings are also consis-

tent with those of Wang and Xiao (2011), who f‌ind that asset

transfer lowers pay-performance sensitivity. However, our

study differs from Wang and Xiao (2011) in several ways.

First, Wang and Xiao (2011) focus on only one tunneling

tactic, assets transfer, which cannot capture the complete

picture of tunneling (Jiang, Lee, & Yue, 2010). In contrast,

our study concentrates on the separated ownership struc-

ture, which is a source of tunneling and a measure of aggre-

gate tunneling incentives (Claessens et al., 2000; Fan &

Wong, 2002; La Porta et al., 1999). Second, Wang and

Xiao (2011) adopt a narrow view of executive incentives

by restricting their analysis to compensation incentives.

However, as Bushman and Smith (2001), Jensen and

Murphy (1990), and Shleifer and Vishny (1997) note, execu-

tive incentives involve compensation contracts and the

threat of dismissal for poor performance. Third, Wang and

Xiao (2011) provide only one possible strategy by which

controlling shareholders collude with managers. Our study

provides further preliminary evidence for rent-sharing

behavior between controlling shareholders and managers.

Second, we contribute to the literature that examines

the contracting value of performance. The literature in this

area suggests that managerial pay and dismissal decisions

CONTROLLING SHAREHOLDER-MANAGER COLLUSION 441

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