Non‐Tradable Share Reform and Corporate Governance in the Chinese Stock Market

• Published date: 01 July 2009
• Author: Tsun‐Siou Lee,Yu‐Hui Su,Yin‐Hua Yeh,Pei‐Gi Shu
• DOI: http://doi.org/10.1111/j.1467-8683.2009.00754.x
• Date: 01 July 2009

Non-Tradable Share Reform and Corporate

Governance in the Chinese Stock Market

Yin-Hua Yeh*, Pei-Gi Shu, Tsun-Siou Lee, and Yu-Hui Su

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Prior to China’s split-share structure reform, domestic A shares were divided into non-tradable

and tradable shares. Non-tradable shareholders represent the government, hold roughly a two-thirds majority,and manage

the f‌irms, while tradable shareholders have little power to affect the decisions made by non-tradable shareholders. This is

a typical structure to exhibit agency problems. The2005 structure reform program stipulates that non-tradable shareholders

have to bargain with tradable shareholders in order to gain liquidity. The price that non-tradable shareholders pay to

tradable shareholders for gaining liquidity is def‌ined as “compensation.”We explore the issue of why corporate governance

might play an important role in affecting the level of compensation.

Research Findings/Insights: Firms with a weak governance structure or severe agency problems are required to have a

higher level of compensation. The level of compensation is positively correlated with the non-tradable shareholding, the

pledge ratio, and related-party transactions, and is negatively correlated with foreign shareholdings. The same set of

variables dictates the ex-post wealth effect of tradable shareholders, but in the reverse direction.

Theoretical/Academic Implications: The share reform providesa natural setting that allows tradable shareholders to ref‌lect

their concerns with agency problems. The mechanism could ameliorate the agency problems. Corporate governance, in a

broad sense, is related to compensation and the ex-post wealth effect of tradable shares.

Practitioner/Policy Implications: A successful mechanism should be designed to have minority shareholders involved in

the process and have the f‌inal compensation ref‌lect the quality of corporate governance.

Keywords: Corporate Governance, Non-tradable Share Reform, Agency Theory, China

INTRODUCTION

In the past few decades, most emerging markets have

attempted to build a strong securities market. However,

it is hard to do at all, and impossible to do quickly. The

central reason why building a strong securities market is so

hard is that the securities market depends on a complex

network of supporting institutions, including government

regulations, enforcement agencies, private market institu-

tions, and a culture of disclosure and honest dealing with

minority shareholders. Some countries have tried to make

the leap from a centrally planned economy to a strongpublic

stock market. However, they failed. For example, the most

aggressive efforts, in Russia (e.g., Barberis. Boycko, Shleifer,

and Tsukanova, 1996; Frydman, Pistor, & Rapaczynski,

1996) and the Czech Republic (e.g., Hingorani, Lehn, &

Makhija, 1997) have crashed and burned.

However, there were exceptions and China is one of the

most widely cited exceptions. China began its moderniza-

tion program in the late 1970s and gradually reformed its

state-owned enterprises (SOEs). In the early 1990s, the gov-

ernment partiallyprivatized some SOEs. For the listed SOEs,

the government launched a split-share structure in which

non-tradable shares were mainly held in the hands of the

government and its aff‌iliates and tradable shares were

mainly held by domestic investors. Non-tradable shares rep-

resented roughly two-thirds of the total shareholdings. In

contrast, tradable shareholders received little protection and

had limited power to affect f‌irm management.

The structure exhibited weak corporategovernance in that

listed subsidiaries engaged in related-partytransactions and

pursued alternative external f‌inancial conduits to support

their poor-performing parent companies. Besides, the gov-

ernment gradually realized that there were other problems

associated with the split-share structure – suppression of

free trading, a volatile domestic market, and runaway of

valuable companies.

*Address for correspondence: Graduate Institute of Finance,Fu-Jen Catholic Univer-

sity, 510, Chung Cheng Rd, Hsin-chuang, Taipei County 24205 Taiwan. Tel: +886-2-

2905-2725; Fax: +886-2-2901-9779; E-mail: trad1003@mail.fju.edu.tw

457

Corporate Governance: An International Review, 2009, 17(4): 457–475

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00754.x

The early initiative in 2001 was to invite companies to sell

their state shares to tradable shareholders without bargain-

ing beforehand with tradable shareholders. This thrust

resulted in a signif‌icant decline in stock prices, about 40 per

cent within 15 days of the announcement. In April 2005, the

government announced a pilot reform program requiring

non-tradable shareholders to bargain with and pay “com-

pensation” to tradable shareholders for gaining the right to

trade. Tradable shareholders have the power to vote and

ultimately decide on whether or not a proposed compensa-

tion plan is approved. Throughout this study, we def‌ine the

“compensation” as the price that non-tradable shareholders

paid to tradable shareholders for gaining liquidity. This def‌i-

nition is commonly used in the literatureregarding the split-

share reform in China (e.g., Beltratti & Bortolotti, 2006; Liao,

Li, Liu, & Wang, 2008; Wang & Chen, 2006). The compensa-

tion can take alternative forms, such as cash, warrants, stock

splits, and, most frequently, bonus shares. For consistency,

all forms of compensation are translated into equivalent

shares received by holders of the tradable shares per share

held. The reform represents one of the most important

experiments ever attempted in an emerging market and one

of the major reasons to account for the rapid growth of

China stock markets.

In this study we explore the issue of why corporate gov-

ernance might play an important role in affecting compen-

sation requested by tradable shareholders. The relation is

intuitively appealing and could be understood as follow:

tradable shareholders when granting liquidity to non-

tradable shareholders would gauge the possible wealth

losses that might incur to them and demand at least equiva-

lent compensation from non-tradable shareholders. When

gauging the ceded liquidity, corporate governance is valu-

able to tradable shareholders because it is readily availableto

them and is supposed to dictate a f‌irm’s value and long-run

performance. This exploration is important to examine

whether minority shareholders’ concerns about the agency

problems embedded in the governance structure could be

manifested in the compensation scheme. The devised mech-

anism that allows minority shareholders to have voices

on their own behalf therefore provides a splendid forum to

examine this issue.

Weexplore corporate governancealong three dimensions –

ownership structure, board structure, and related-party

transactions – on the premise that ownership and board

structure represent the power and surveillance function

within a f‌irm, as well as dictating the resourceallocation and

operations of a f‌irm. Related-party transactions are included

as they are known to be related to wealth exploitation and

tunneling practices in China (e.g., Berkman,Cole, & Fu, 2009;

Jian, Wong, & Ming, 2008; Jiang, Lee, &Yue, 2005). Also, the

information about the three dimensions is open to the public

and accessible to tradable shareholders. With this informa-

tion in hand, tradable shareholders are able to gauge the

potential wealth losses from granting liquidity. We note that

liquidity is of value to shareholders (Brenner, Eldor, &

Hauser, 2001; Kahl, Liu, & Longstaff, 2003; Longstaff, 1995).

In granting liquidity to non-tradable shareholders, tradable

shareholders will demand compensation for the ceded value.

We postulate that the level of compensation is negatively

affected by the f‌irm’s corporate governance. However,

before investigating the relationship between corporategov-

ernance and compensation, we need to discuss some oppos-

ing arguments. First, we explore the possibility that

corporate governance has been rationally factored into the

share prices before the reform and is therefore unrelated to

compensation. We argue that this case is less likely because

some wealth-expropriatingactivities, such as insider trading

and information manipulation for selling shares at higher

price, are associated with share transferability that was not

accessible to non-tradable shareholders before the reform.

When given the option of making decisions, tradable share-

holders will reevaluate the f‌irm’s governance structure and

factor it into the negotiation for compensation.

Second, is it possible that compensation is positively

related to the quality of a f‌irm’s governance because the

tradable shareholders of f‌irms with poor corporate gover-

nance might perceive a big potential benef‌it from the

improvement of corporate governance and therefore

demand less compensation? We f‌ind that this is also less

likely to happen becausenon-tradable shareholders retained

tight control over a f‌irm even after the reform. According to

statistics, non-tradable shareholding after the reform (51.7

per cent) remains predominant,only somewhat lower than it

was before (62.4 per cent).

Moreover, can we simply assume that tradable sharehold-

ers are passive, leading to a weak linkage between corporate

governance and compensation? This is not an issue because

the mechanism is designed to allow tradable shareholders to

explicitly express their opinions and make the f‌inal call on

the compensation proposal. According to a study of Li,

Wang, Cheung, and Jiang (2007), only 15 per cent of the

originally proposed compensation schemes were accepted

by tradable shareholders, leaving 85 per cent of the cases to

be concluded with a revised scheme.

Our sample of 534 reform f‌irms in the sampling period of

April 2005 through April 2006 verif‌ies our postulation that

compensation is closely related to the f‌irm’s corporate gov-

ernance. Specif‌ically, compensation is positively affected by

the ratio of non-tradable shares, the percentage of sharehold-

ings that controlling shareholders pledge for bank loans

(pledge ratio), and related-party transactions, and negatively

affected by the debt ratio and foreign shareholdings. We

trace the subsequent wealth effect that is calculated against

the value on the last trading day before launching the deal.

The median relative wealth on the f‌irst trading day is 102.5

per cent, and drops to 93 per cent on the ninetieth trading

day after the deal. In addition, the concerns of price impact

and wealth embezzlement are ref‌lected in the subsequent

wealth loss, which is negatively correlated with related-

party transactions.

Most existing literature of the privatization of state owned

enterprises mainly focuses on the process of the privatization

initial offering, the initial return, and the long term return of

participating investors to measure their gain or loss (e.g.,

Ausenegg, 2000; Choi & Nam, 2000; Dewnter & Malatesta,

1997; Jones, Megginson, Nash, & Netter, 1999; Menyah &

Paudyal, 1996; Su & Fleisher, 1999). Another trail of the

literature that focuses on China includes depiction of the

reform process (Cao, Qian, & Weingast, 1999; Gao, 1996;

Groves, Hong, McMillan, & Naughton, 1994; Lin & Zhu,

2001) and analyses of the effectiveness of these reforms

458 CORPORATE GOVERNANCE

Volume 17 Number 4 July 2009 © 2009 Blackwell Publishing Ltd