State Control, Legal Investor Protection, and Ownership Concentration: Evidence from China

• Published date: 01 March 2009
• Date: 01 March 2009
• Author: Nianhang Xu,Qingbo Yuan,Shinong Wu
• DOI: http://doi.org/10.1111/j.1467-8683.2009.00731.x

State Control, Legal Investor Protection, and

Ownership Concentration: Evidence from China

Shinong Wu, Nianhang Xu,* and Qingbo Yuan

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: To control for the omitted-variables and aggregation biases problem existing in previous cross-

country studies, our paper investigates the relationship of ownership concentration and legal investor protection across

regions and over time in one emerging economy, China, during the period 1992 to 2003. Moreover, this paper examines

whether state control affects this relationship.

Research Findings/Results: For state-controlled f‌irms, we cannot f‌ind the typical inverse relationship between ownership

concentration and legal investor protection documented by La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998), since

state per se works as a substitute for formal legal investor protection in protecting property rights by exploiting political

power. However, for non-state-controlled f‌irms, the inverse relationship does hold.

Theoretical Implications: Our f‌indings suggest that the nature of the controlling shareholder should be taken into account

when examining the relationship between ownership concentration and legal investor protection. Moreover, our f‌indings

give new insights, especially to the study on other emerging economies thatshare similar characteristics with China in terms

of legal development and government control. Finally, the cross-region study within one country provides a new perspec-

tive on the research in this area.

Practitioner Implications: First, to provide a level playing f‌ield for different types of investors, the state’s dual role of

controlling shareholder and political power holder should be separated. Second, it is important to build up a good legal

system to protect investors in order for a country to develop its capital markets, especially for the development of the

non-state sector.

Keywords: Corporate Governance, Shareholder Rights, State-Owned Enterprise, Legal Effectiveness, China

INTRODUCTION

Recent research reveals that a number of important dif-

ferences in f‌inancial systems among countries are

shaped by the quality of legal rules protecting outside inves-

tors (La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1998;

Denis and McConnell, 2003; Mintz, 2005). One prominent

issue in this literature is the relationship between ownership

structure and legal investor protection. Empirical evidence

from La Porta et al. (1998: 1145) indicates that ownership is,

on average, more concentrated in countries with poor legal

investor protection, which leads them to argue that “with

poor investor protection, ownership concentration becomes

a substitute for legal protection, because only large share-

holders can hope to receive a return on their investment.”

Following La Porta et al. (1998), a number of cross-country

comparative studies attempt to test the inverse relationship

between ownership concentration and legal protection

(Dyck, 2000; Himmelberg, Hubbard and Love, 2002;

Boubakri, Cosset and Guedhami, 2005). However, the cross-

country comparisons usually use country average data,

which creates omitted-variables and aggregation biases

because it is companies, and not countries, that have large

shareholders and country averages discard much informa-

tion, including all within-country variation in ownership

concentration (Holderness, 2008). Consequently, the investi-

gation of regional or provincial level variation in cultural and

legal constraints within one country would be a fruitful

research direction, as there is considerable explanatory

power of within-country regional or provincial level vari-

ables, while keeping everything else constant (Clark, 1990;

Lenartowicz and Roth, 2001; Chavez, 2003; Trochev, 2004;

Sarno, 2008).

Moreover, while the cross-country comparative studies in

this f‌ield have advanced considerably, little is known about

*Address for correspondence: Department of Finance, Guanghua School of Manage-

ment, Peking University,Beijing 100871, P. R. China. Email: hang78@sina.com

176

Corporate Governance: An International Review, 2009, 17(2): 176–192

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00731.x

how ownership concentration changes in response to

changes in legal rules within countries, especially in emerg-

ing economies.1Driven by the desire to rapidly catch up

with the high level of legal protection in Western countries,

emerging economies borrowed a lot of legal rules and expe-

riences from the United States and other developed coun-

tries. But the dynamic effect of these legal reforms is still not

very clear. Dyck (2000) argues that one important tool for

conducting research in this area is the identif‌ication of a

sequence in the introduction of various legal protection

rules, and the source of such evidence lies in more in-depth

historical studies, not in a cross-sectional approach. Claes-

sens and Fan (2002) also point out that one of the valuable

research directions in corporate governance is to examine

how ownership and governance structures evolve over time,

as well as associated legal and regulatory changes.

Another aspect that is overlooked by the extant literature

when examining the relationship between ownership con-

centration and legal investor protection is the identity of the

controlling owner – the other key dimension of ownership

structure. On the one hand, when legal protection is ineffec-

tive, ownership identity can also provide the function of

governance (Dyck, 2000). On the other hand, one important

type of controlling shareholder is the state, which controls a

signif‌icant number of listed f‌irms (La Porta, Lopez-de-

Silanes and Shleifer, 1999; Claessens and Fan, 2002). The

state as owner faces many conf‌licts of interest, as it not only

acts as the controlling shareholder, it also has political

power that could help protect its property rights as share-

holder. The state, as a substitute for legal protection of inves-

tors, can use political power to enforce contracts between

the f‌irms they control and other stakeholders. Consequently,

the impact of legal protection on ownership concentration is

likely different between state-controlled f‌irms and non-state-

controlled f‌irms. However, until recently, whether and how

the identity of the owner impacts the relationship between

ownership concentration and legal investor protection was

still not clear.

To f‌ill the void in the extant literature, this study seeks to

investigate in depth the effects of legal protection on f‌irm’s

ownership concentration for state-controlled and non-state

controlled f‌irms separately within one important emerging

economy, China, by exploiting the heterogeneity of legal

investor protections across regions and the dynamic legal

development related to the protection of minority investors

over time during the period 1992 to 2003. China offers a

suitable setting to test the dynamic relationship between

legal investor protection and ownership concentration for

the following reasons. First, because of its vast territory and

decentralized political and economic systems since 1978,

China exhibits great heterogeneity in legal institutions

across its various regions, i.e., 31 provinces (Qian and Wein-

gast, 1997; Jin, Qian and Weingast, 2005). This creates a

natural laboratory to examine cross-sectionally how legal

environment affects ownership concentration while avoid-

ing the omitted correlated variable problem generally exist-

ing in cross-country studies. Second, by the end of 2003,

China had transplanted a number of “laws on the book”

from developed countries to protect minority investors. The

formal written rule to protect investors has experienced a

progressive development and improved signif‌icantly during

the period 1992 to 2003 (MacNeil, 2002), providing us with a

good opportunity to test the effects of these dynamic legal

reforms. Third, in China, during the 1990s, a lot of state-

owned enterprises (SOEs) were allowed to be partially

privatized by issuing a minority allocation of shares to indi-

vidual investors. After privatization, the state still controls

most listed f‌irms. Thus, these partially privatized f‌irms

provide an ideal dataset to examine whether legal protection

helps to explain the ownership concentration at the time of

initial public offering (IPO) and the evolution of ownership

concentration (Dyck, 2000), and how state control inf‌luences

this relationship.

From both cross-sectional and longitudinal perspectives,

our regression results show that the typical inverse relation-

ship between ownership concentration and legal investor

protection documented by La Porta et al. (1998) can not be

found for state-controlled f‌irms in China since the state per

se works as a substitute for formal legal investor protection

in protecting property rights. However, for non-state-

controlled f‌irms, the inverse relationship does hold.

The remainder of the paper is organized as follows. The

next section reviews the literature and develops hypotheses.

This is followed by the research design. The following

section discusses our empirical results. The f‌inal section con-

cludes the paper.

LITERATURE REVIEW AND HYPOTHESIS

DEVELOPMENT

Literature Review

The Berle and Means (1932) paradigm, with widely held

f‌irms and the conf‌lict between professional managers and

dispersed shareholders, has been a traditional image of

ownership of the modern corporations since the 1930s.

However, recently, La Porta et al. (1999) show that concen-

trated ownership is the norm, not the exception, in large

corporations of most countries. La Porta et al. (1998) point

out that, in this situation, the fundamental agency problem

is not the Berle–Means conf‌lict between minority investors

and managers, but rather between minority investors and

controlling shareholders. Johnson, La Porta, Lopez-de-

Silanes and Shleifer (2000) argue that the expropriation of

minority shareholders by the controlling shareholders is

extensive in many countries. Then, how can it be limited?

The legal approach to corporate governance holds that

the key mechanism is the protection of minority inve-

stors through the legal system, because it can make the

expropriation technology less eff‌icient (La Porta et al.

2000).

Some of the theoretical literature develops models to

examine the link between ownership structure and legal

protection. Himmelberg et al. (2002) derive an inverse rela-

tionship between ownership concentration and the quality

of the law based on the classical trade-off between incentives

and risk. Shleifer and Wolfenzon (2002) examine the impact

of legal protection in a market equilibrium model. In these

two papers, better legal protection enables a wealth-

constrained entrepreneur to raise more outside funds,

thereby lowering the fraction that the entrepreneur’s wealth

STATE CONTROL, LEGAL INVESTOR PROTECTION, AND OWNERSHIP CONCENTRATION 177

Volume 17 Number 2 March 2009© 2009 Blackwell Publishing Ltd