State ownership and securities fraud: A political governance perspective

• Author: Kai Wang,Wei Shi,Ruth Aguilera
• DOI: http://doi.org/10.1111/corg.12313
• Published date: 01 March 2020
• Date: 01 March 2020

ORIGINAL ARTICLE

State ownership and securities fraud: A political governance

perspective

Wei Shi

1

| Ruth Aguilera

2

| Kai Wang

3

1

Miami Herbert Business School, University of

Miami, Coral Gables, Florida

2

D'Amore-McKim School of Business,

Northeastern University, Boston,

Massachusetts

3

College of Business Administration, Capital

University of Economics and Business, Beijing,

China

Correspondence

Kai Wang, College of Business Administration,

Capital University of Economics and Business,

No. 121, Zhangjialukou, Fengtai District,

Beijing 100070, China.

Email: wangkai@cueb.edu.cn

Funding information

Scientific Research Plan of Beijing Municipal

Education Commission, Grant/Award Number:

SM202010038015; National Natural Science

Foundation of China, Grant/Award Numbers:

71972111, 71702114

Abstract

Research question/issue: This study attempts to shed new light on how the state as

a controlling shareholder can affect the interests of minority shareholders by investi-

gating the role of state ownership in deterring securities fraud commission.

Research findings/insights: Using archival data from a large sample of Chinese pub-

licly traded firms, we uncover that state ownership is negatively associated with the

likelihood of securities fraud commission. Further, CEO political background rein-

forces this negative relationship. We also uncover that firms with high state owner-

ship are more likely to dismiss CEOs than those with low or no state ownership upon

securities fraud detection.

Theoretical/academic implications: Departing from agency theory-centric research

on state ownership and corporate governance, this study introduces a political gover-

nance perspective to unpack the role of state ownership in corporate governance.

Political governance refers to organizational control mechanisms deployed by politi-

cal actors to achieve their objectives.

Practitioner/policy implications: Studying how political governance systems influ-

ence managerial behaviors is critical to gaining a complete insight into the implica-

tions of state ownership on corporate governance.

KEYWORDS

Corporate governance, CEO dismissal, ownership, securities fraud, state ownership

1|INTRODUCTION

After over two decades of extensive state reforms and privatization,

firms with state ownership still loom large both in developing and

developed countries. A plethora of research has investigated how

state ownership can affect the quality of corporate governance

(Bruton, Peng, Ahlstrom, Stan, & Xu, 2015; Grosman, Aguilera, &

Wright, 2019; Grosman, Okhmatovskiy, & Wright, 2016; Musacchio,

Lazzarini, & Aguilera, 2015). Most of existing studies (Jiang, Lee, &

Yue, 2010; Liu & Sun, 2005; Megginson & Netter, 2001; Shleifer &

Vishny, 1997) draw upon agency theory to argue that the state as a

controlling shareholder can be detrimental to effective corporate gov-

ernance and harm the interests of minority shareholders because the

state controls the appointment of board members and top managers,

but the state's priorities often differ from those of minority share-

holders (Young, Peng, Ahlstrom, Bruton, & Jiang, 2008).

This study attempts to introduce a political governance perspec-

tive to understand the implications of state ownership on corporate

governance by investigating the influence of state ownership on secu-

rities fraud. Political governance refers to control mechanisms used by

political actors to achieve their political objectives (Wang, 2014a). The

importance of political governance is particularly salient in Chinese

state-owned enterprises (SOEs) because the ultimate goal of the state,

controlled by the Chinese Communist Party (CCP), is to gain and safe-

guard its political legitimacy (Donald, 2016; Greve & Zhang, 2017;

Wang, 2014a; Zhou, Gao, & Zhao, 2017). Securities fraud refers to

deceptive practices used by firms to induce investors to make pur-

chase or sale decisions on the basis of false information (Cumming,

Received: 4 January 2019 Revised: 17 January 2020 Accepted: 27 January 2020

DOI: 10.1111/corg.12313

Corp Govern Int Rev. 2020;28:157–176. wileyonlinelibrary.com/journal/corg © 2020 John Wiley & Sons Ltd 157

Leung, & Rui, 2015). We choose to test the implications of political

governance associated with state ownership in the context of securi-

ties fraud because securities fraud, compared with other types of cor-

porate misconduct, can directly hurt the interests of numerous retail

investors and is highly visible. In particular, in China, firms on average

lose between 15% and 25% of their value when government agencies

announce securities fraud investigations (Chen, Firth, Gao, & Rui,

2005). Therefore, investors are highly attentive to securities fraud. In

addition, investigating what affects corporate misconduct (including

securities fraud) is an important topic in governance research because

effective governance is partly designed to prevent corporate miscon-

duct (Mohliver, 2019; Neville, Byron, Post, & Ward, 2019; Schnatterly,

Gangloff, & Tuschke, 2018; Zorn, Shropshire, Martin, Combs, &

Ketchen, 2017).

We argue that political governance associated with state owner-

ship can deter securities fraud commission for two reasons. First, the

state's primary objective in their involvement in SOEs is generally first

and foremost to accomplish political and social goals rather than to

generate financialprofits (Bai & Xu, 2005; Stan, Peng, & Bruton, 2014).

Therefore, the state as a shareholder is less likely to impose financial

performance pressure on managers. Meanwhile, managers are less

likely to engage in corporate misconduct in the absence of financial

performance pressure (Schnatterly et al., 2018; Shi, Connelly, &

Hoskisson, 2017). Second, as noted, securities fraud is a type of high-

profile misconductthat can harm financial interests of numerous inves-

tors. Thus, associating state ownership with securities fraud can be

detrimental to the political legitimacy of the CCP rule. Consequently,

we argue that the CCP will enforce stronger disciplinary actions on

managers of firms with higher state ownership who have committed

securities fraud, deterringthe occurrence of securities fraud.

We then propose that the negative influence of state ownership

on securities fraud hinges on the CEOs' political background. CEOs

with political background in SOEs are likely or even expected to

return to politics and become higher-level government officials (Lin,

2013). Meanwhile, engaging in securities fraud can call an end to their

political careers (Wang, 2014a). In addition, although firms with high

state ownership are less likely to commit securities fraud than those

with low or no state ownership, the former are more inclined to dis-

miss their CEOs upon fraud detection than the latter. This is because

the Party-state

1

pays great attention to whether managers of SOEs

have conducted themselves to safeguard its political legitimacy

(Wang, 2014a) and securities fraud, a conspicuous form of corporate

misconduct, can adversely affect the Party's political legitimacy

(Arjoon, 2005).

Using a large sample of Chinese publicly traded firms, we find

support for our arguments using bivariate probit regressions with par-

tial observability that control for the influence of state ownership on

fraud detection. Our study makes two significant contributions to the

corporate governance literature. First, we enhance our insights into

research on state ownership and corporate governance. To date, state

ownership is generally perceived, as detrimental to effective corporate

governance and the interests of minority shareholders (Grosman

et al., 2016; Megginson & Netter, 2001). We argue that political

governance associated with state ownership can deter managers from

committing securities fraud, advancing our knowledge about the role

of state ownership in corporate governance. Second, the role of own-

ership structure has been a core topic in corporate misconduct (Burns,

Kedia, & Lipson, 2010; Cheng & Firth, 2005; Hadani, Goranova, &

Khan, 2011; Shi et al., 2017). We extend and test this body of work

within the context of concentrated ownership, more salient outside

North America, contributing to corporate governance research in

emerging economies (Armitage, Hou, Sarkar, & Talaulicar, 2017).

2|THEORETICAL BACKGROUND

2.1 |State ownership and corporate governance

State ownership does not dissipate with the advancement of market

economies, and as a matter of fact, SOEs generate around one tenth

of world gross domestic product and account for around 20% of

global equity market value (Economist, 2012). Agency theory suggests

that the state as a controlling shareholder can adversely affect the

interests of non-state minority shareholders (Borisova, Brockman,

Salas, & Zagorchev, 2012; Shleifer & Vishny, 1997). Specifically,

agency theory assumes interest conflicts among principals (Young

et al., 2008). The state as a controlling shareholder may have interests

different from minority shareholders and attempts to influence firm

decisions that benefit the interests of the state but not the minority

shareholders (e.g., through appointing board members or top

managers).

SOEs' top managers are evaluated mostly based on whether they

have fulfilled political and social goals (Du, Tang, & Young, 2012).

Therefore, CEO compensation bears a weak association with firm

financial performance among firms with the state as a controlling

shareholder (Firth, Fung, & Rui, 2006b). In addition, SOEs have a lower

CEO turnover-performance sensitivity than privately owned enter-

prises (POEs; Kato & Long, 2006). Furthermore, SOEs in emerging

economies such as China often receive financial and policy support

from the government and do not face the pressure from external gov-

ernance mechanisms (such as the market for corporate control and

investor activism; Jiang et al., 2010). As a result, SOEs exhibit lower

investment efficiencies (Chen, El Ghoul, Guedhami, & Wang, 2017)

and lower propensities for corporate risk-taking than POEs (Boubakri,

Cosset, & Saffar, 2013). All of these consequences can potentially

harm the interests of minority shareholders.

In addition, the state as a controlling shareholder may engage in

related-party transactions to tunnel resources from listed subsidiary

firms to other underperforming subsidiaries (Jiang et al., 2010). Relat-

edly, the state can harm the interests of the minority shareholders

when it forces firms to appoint politicians as managers or to pursue

projects on the basis of political and social returns instead of financial

returns (Cuervo & Villalonga, 2000; Dharwadkar, George, & Brandes,

2000; Shleifer, 1998). Further, SOEs can become tools for politicians

and friends of the state to advance their own political interests

(Boycko, Shleifer, & Vishny, 1996; Shleifer & Vishny, 1994).

158 SHI ET AL.