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

• Date: 01 May 2012
• Published date: 01 May 2012
• Author: Nancy Huyghebaert,Lihong Wang
• DOI: http://doi.org/10.1111/j.1467-8683.2012.00909.x

Expropriation of Minority Investors in Chinese

Listed Firms: The Role of Internal and External

Corporate Governance Mechanisms

Nancy Huyghebaert and Lihong Wang*

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 charac-

teristics, 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 impli-

cations 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.

Keywords: Corporate Governance, Minority Rights, Ownership Mechanisms, Board Composition, Institutional Quality

INTRODUCTION

The arguments in agency theory usually relate to large

corporations with dispersed ownership and with the

most well-known problem of corporate governance: the

conf‌lict of interest between managers and shareholders

(Berle & Means, 1932; Jensen & Meckling, 1976). Yet, in many

countries, both listed and non-listed f‌irms have an indi-

vidual, a family, or the state as their dominant owner (Claes-

sens, Djankov, & Lang, 2000; La Porta, Lopez-de-Silanes,

Shleifer, & Vishny, 1999; Shleifer & Vishny, 1997). In such a

context, principals cannot be treated as a single entity with

common interests. Owners may indeed have divergent pref-

erences for risk and returns, private costs of monitoring, and

*Address for correspondence: Lihong Wang, Institute for Financial and Accounting

Studies, Xiamen University,Siming Nanlu 422, 361005 Xiamen, China. Tel: +86-(0)592

2183955; Fax: +86-(0)592-2181787; E-mail: LihongWang@xmu.edu.cn

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Corporate Governance: An International Review, 2012, 20(3): 308–332

© 2012 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2012.00909.x

strategic motivations for investing in a company (Su, Xu, &

Phan, 2008). Moreover, a controlling shareholder may have

the power as well as the incentives to divert corporate

resources to himself, extracting private benef‌its of control.

Recent corporate governance research shows that such

principal-principal conf‌licts of interest are especially pro-

nounced in a context characterized by concentrated owner-

ship and by a weak legal protection of property rights, as

applies to many emerging countries and economies in tran-

sition (e.g., Claessens & Fan, 2002; La Porta, Lopez-de-

Silanes, Shleifer, & Vishny, 2000; Young, Peng, Bruton, &

Jiang, 2008). These studies also focus on how to mitigate

minority-investor expropriation, thereby indicating that

solutions may differ from those required for resolving tra-

ditional managerial agency problems (Berkman, Cole, & Fu,

2009; Cheung, Rau, & Stouraitis, 2006, 2010; Dharwadkar,

George, & Brandes, 2000; Young et al., 2008).

In this article, we focus on minority-investor expropria-

tion in China, the world’s largest economy in transition.1

Publicly traded f‌irms in China typically have a large control-

ling shareholder, who has the ability to appoint and to

monitor the management, but at the same time has the

power to tunnel wealth from small outside investors. As the

property rights of stock market investors in China are in

general not well protected due to weak legal enforcement,

dominant owners may f‌ind it worthwhile to engage in self-

dealing transactions. A number of recent studies have

shown that tunneling – proxied by related-party transactions

(hereafter RPT) and by loans/loanguarantees issued to large

shareholders – is indeed a serious problem. For example,

Cheung, Jing, Lu, Rau, and Stouraitis (2009) f‌ind that stock

market investors in China respond negatively to announce-

ments of RPT that are potentially harmful to the listed f‌irm.

Cheung et al. further show that the fraction of state owner-

ship is positively associated with value-destroying RPT,

while the effect of external directors, the presence of big-four

auditors, and cross-listing is not signif‌icant. Similar results

are obtained by Zhu and Ma (2009) and Jian and Wong

(2010). In addition, Jian and Wong point out that abnormal

sales to related enterprises are smaller in regions with a

larger number of special economic zones and a larger f‌iscal

surplus. Yet, they f‌ind no impact of regional market devel-

opment, measured by a regional marketization index. More-

over, Berkman et al. (2009) examine loan guarantees issued

by Chinese listed f‌irms to their controlling shareholder.

Unlike prior research, they conclude that tunneling is less

likely in state-controlled f‌irms. Finally, Jiang, Lee, and Yue

(2010) document the widespread use of inter-corporate

loans by dominant owners to extract funds from Chinese

listed f‌irms. Again,they f‌ind a negative effect for the dummy

capturing state control. Moreover, the problem of tunneling

is marginally attenuated if the f‌irm is located in a more

developed region of the country, proxied by the same index

as used by Jian and Wong (2010).

Although prior research has clearly pointed out the exist-

ence of a conf‌lict of interest between majority and minority

investors in Chinese listed f‌irms, we identif‌ied a number of

open issues in the literature. Most importantly, we relate

these knowledge gaps to the unique composition of Chinese

domestic stock markets, with many listed f‌irms being

former state-owned enterprises (SOEs) that became listed

through share issuing privatization (SIP) and that remained

controlled by the Chinese state after SIP. First, we argue that

the role of the government in the operation of these listed

SOEs is typically more elaborate than that of a private domi-

nant owner. Specif‌ically, on top of economic considerations,

the state could exercise its control rights to achieve some

imperative social and political objectives, to the detriment

of external investors (Shleifer & Vishny, 1994, 1997). For

example, the state may wish to cross-subsidize other SOEs

encountering f‌inancial diff‌iculties to keep these f‌irms af‌loat,

or it could refuse to lay off excess personnel to maintain

social stability. In contrast, large private owners tend to be

motivated solely by private benef‌its when engaging in tun-

neling. So, the Chinese case allows us to investigate an addi-

tional form of expropriation that usually does not arise in

the context of more developed economies. Our approach

regarding these costs of political control is fundamentally

different from that in the public governance literature to

date, pointing at a conf‌lict of interest because of the private

interests of politicians and bureaucratsrepresenting the state

(e.g., Benz & Frey, 2007; Calabrò & Torchia, 2011). To better

isolate these costs of political control, we calculate a new

measure capturing the f‌irm’s labor redundancy. Besides, we

clearly identify the stake held by the state, considering also

its indirect inf‌luence in listed SOEs through legal persons.

Next, we examine various aspects of state ownership,includ-

ing the government’s control rights as well as its cash f‌low

rights. Research to date has only accounted for government

ownership in a rather narrow way, either by the fraction of

state shares (Cheung et al., 2009) or by a dummy for state

control (Berkman et al., 2009; Jian & Wong, 2010; Jiang et al.,

2010; Zhu & Ma, 2009). Possibly, our more comprehensive

approach can help to resolve some of the ambiguities

regarding the role of the Chinese state in explaining

minority-investor expropriation.

Second, many uncertainties remain regarding the effects

of various corporate governance mechanisms on

principal-principal conf‌licts of interest in Chinese listed

f‌irms. For example, while Young et al. (2008) emphasize

the importance of board independence from controlling

shareholders to protect minority rights in emerging econo-

mies, independent directors typically cannot help small

outside investors in China (Cheung et al., 2009; Zhu & Ma,

2009). In addition, a series of seminal studies by La Porta,

Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998, 1999,

2000) emphasize the role played by institutions. Yet,

studies on China have found only limited evidence on

the benef‌icial effects of institutional development (Jian &

Wong, 2010; Jiang et al., 2010). We explore the possibility

that the state as dominant owner might reduce the effective

role of various governance mechanisms in mitigating

expropriation. As an example, the Chinese state frequently

appoints bureaucrats and politicians to the management

and on the board of listed SOEs (Bai, Liu, Lu, Song, &

Zhang, 2004). As the government also largely controls the

political career of these off‌icials, board independence in

listed SOEs becomes questionable. Moreover, independent

directors in listed SOEs are very often retired government

off‌icials, who continue to see their f‌iduciary duty vis-à-vis

the state. Next, the government as dominant owner might

reduce the positive effects of external governance mecha-

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Volume 20 Number 3 May 2012© 2012 Blackwell Publishing Ltd