The Value of Relationship-based and Market-based Contracting: Evidence from Corporate Scandals in China

Transcription

1 The Value of Relationship-based and Market-based Contracting: Evidence from Corporate Scandals in China Mingyi Hung Leventhal School of Accounting Marshall School of Business University of Southern California Los Angeles, CA T.J. Wong School of Accountancy The Chinese University of Hong Kong Shatin, N.T., Hong Kong Fang Zhang Department of Accountancy and Law Hong Kong Baptist University Kowloon, Hong Kong May 2012 Acknowledgments: The work described in this paper was fully supported by Grant No. CUHK from the Research Grants Council of the Hong Kong Special Administrative Region, China. We thank Andreas Charitou, Mark DeFond, Zhaoyang Gu, Luzi Hail, Pierre Liang, Hai Lu, Joseph Piotroski, Tianyu Zhang, and workshop participants at Carnegie Mellon University, the Chinese University of Hong Kong, the University of Southern California, and the 35 th Annual Congress of European Accounting Association for their helpful comments.

2 The Value of Relationship-based and Market-based Contracting: Evidence from Corporate Scandals in China Abstract This paper compares the value of relationship-based and market-based contracting in China by examining the consequence of corporate scandals, defined as enforcement actions against firms or their managers by Chinese courts and securities regulators. Since contracts are primarily conducted based on political relationships rather than market mechanisms in China, we hypothesize that scandals such as bribery of government officials that sever firms political ties are more damaging than scandals such as misrepresentation of financial statements that hurt firms market credibility. To test this hypothesis, we categorize 212 Chinese corporate scandals from by whether the scandal primarily damages i) the firm s political networks and hence its ability to conduct relationship-based contracting (relationship scandals), ii) the firm s market credibility and thus its ability to conduct market-based contracting (market scandals), or iii) both (mixed scandals). Consistent with our hypothesis, we find that the stock market reacts more negatively to relationship and mixed scandals than to market scandals, and this result holds with or without controlling for the magnitude of scandals, average stock price and earnings performance prior to the scandals, and legal penalties imposed on the firms and individuals. In addition, firms involved with relationship and mixed scandals experience worse stock returns when they rely more on political networks. We also find that, compared to market scandals, relationship and mixed scandals lead to greater departure of political and affiliated directors and larger decreases in loans from stateowned banks.

3 The Value of Relationship-based and Market-based Contracting: Evidence from Corporate Scandals in China 1. Introduction Corporate misconduct is a key concern for investors and regulators worldwide. Prior studies on corporate scandals generally focus on financial misrepresentation in marketbased economies such as the U.S. (Karpoff et al., 2008a; Keida and Philippon, 2009). These studies find that U.S. firms experience huge losses in firm value if they are targeted by SEC enforcement actions for financial misrepresentation, consistent with credible accounting disclosure being critical for investors to conduct market-based arm s length contracting (Rajan and Zingales, 1998). The literature, however, provides little insight on the impact of corporate scandals in relationship-based economies, such as most emerging economies, where markets tend to be less developed. In these economies, firms rely heavily on their owners and senior executives political and social networks to conduct business. Thus, while corporate scandals in the U.S. destroy firm value largely by damaging firms ability to conduct market-based contracting, corporate scandals in emerging economies such as China can destroy firm value in two important ways: (1) by shaking the market s confidence, which hurts firms ability to conduct market-based contracting, and (2) by severing firms political and social ties, which hurts firms ability to conduct relationship-based contracting. The purpose of this study is to provide evidence on the value of relationship-based contracting and market-based contracting in China. We estimate the value of relationshipbased and market-based contracting using events that destroy firms abilities to conduct 1

4 future contracts (i.e., corporate scandals). To the best of our knowledge, this is the first paper that compares the market reactions to the destruction of the two types of contracting ability. While it is important to understand different contracting arrangements of firms and their values, prior studies generally focus on documenting firm value decline due to disruption in a specific type of contracting ability. Using U.S. data, Karpoff et al. (2008a) document a significant share price decline from scandals that damage firms ability to engage in market-based contracting. Studies in East Asia also suggest that severing political ties would lead to negative share price decline because weakened political support from the government hurts firms ability to obtain implicit and explicit contracts from the government (Fisman, 1998; Johnson and Mitton, 2003; Leuz and Oberholzer-Gee, 2006). 1 In addition, since firms within the same political network rely critically on political connections for contracting, managers loss of political connections also hurts their firms ability to engage in relationship contracting with other firms. Focusing on corporate scandals in China offers a unique opportunity to compare the value of relationship-based and market-based contracting for two reasons. First, as the world s second-largest economy, China provides a large variety of corporate scandals and rich market depth for our empirical tests. Second, while the Chinese government has introduced significant market reforms to facilitate market-based contracting over the past three decades, relationship-based contracting via political networks remains crucial in China due to strong government intervention in the corporate sector. We expect that in China the value of relationship-based contracting is higher than that of market-based 1 Implicit contracts include government subsidies and tax breaks. In this study, we do not distinguish how relationship and mixed scandals damage firms ability to engage in explicit versus implicit contracting. 2

5 contracting because contracts are conducted based on political relationships to a greater extent than market mechanisms (Lin et al., 1996; DeFond et al.; 2000; Fan et al., 2008; Wang et al., 2008; Hung et al., 2012). Thus, we hypothesize that scandals that sever firms political ties are associated with greater losses in firm value than scandals that hurt firms market credibility in China. There are potential forces that act to attenuate the impact of scandals that sever firms political ties. Specifically, prior research suggests that while political ties enable firms to receive significant economic benefits, they also impose substantial costs on firms. Fan et al. (2007) find that strong government intervention can be costly to minority shareholders (e.g. firms need to provide excessive employment and build infrastructure for the regions they operate in). Corporate scandals are misconduct that breaks the government s trust in the firms involved. It is likely to significantly damage their ability to receive economic benefits from relationship contracting but it is unlikely to free them from the strong government intervention. To the extent that corporate scandals would reduce government intervention to the firms as described in Fan et al. (2007), it would bias against our results. We test our hypothesis using a sample of 212 Chinese corporate scandals over the period. As in prior studies (Karpoff et al., 2008a, b), we identify firms engaged in misconduct using regulatory enforcement actions. Specifically, we identify corporate scandals as enforcement actions against firms or their managers by Chinese courts or securities regulators. 2 These enforcement actions include not only financial 2 We include a firm in our sample if it has an enforcement action or investigation inquiry by the government. Seven of our sample firms were cleared of wrongdoing at the end of investigation. 3

6 misrepresentation, but also asset misappropriation and bribery. Based on the type of contracting ability these corporate scandals destroy, we classify them into one of three categories: relationship scandals, market scandals, and mixed scandals. We first identify 26 scandals as relationship scandals -- scandals that primarily damage political networks and hurt firms ability to conduct relationship contracting. 3 Examples of relationship scandals include managers bribing the government or stealing from the state through tax evasion. These scandals do not necessarily harm a firm s outside shareholders or stakeholders (e.g., suppliers and customers), and in some bribery cases may even help transfer government resources to the firm. 4 However, while such scandals may not hurt a firm s ability to conduct market-based contracting, they damage the firm s political networks because the state will lose trust in the firm s board and may even arrest the government official that previously granted favors to the firm. This disruption in political connections will reduce firms ability to engage in relationshipbased contracting. Next, we identify 91 market scandals -- scandals that primarily damage market confidence and hurt firms ability to conduct market-based contracting. One example of a market scandal is financial misrepresentation, because accounting disclosure is critical for outside stakeholders decisions in doing business with the firm. Another example is 3 We focus on political networks because prior research documents that politics plays a key role in governance structure, auditor choice, IPOs, and debt financing of listed firms in China (Aharony et al., 2000; Fan et al., 2007, 2008; Wang et al., 2008). While social networks are also likely to be important for relationship contracting, we leave examination of social networks to future research. 4 Although these forms of misconduct, similar to all other scandals, may cause the market to question management integrity, their primary effect on the offending firm s contracting ability is likely to come from direct offenses against the government rather than from direct offenses against outside shareholders and stakeholders. 4

7 managers misappropriating firm assets, for instance, through embezzlement, kickbacks, or tunneling, because these types of actions effectively involve theft from shareholders. Finally, we identify 95 mixed scandals, which are scandals that impair firms ability to conduct both relationship-based and market-based contracting. An example of a mixed scandal is embezzlement by managers of state-owned enterprises (SOEs). Embezzlement by managers, that is, the theft of firm assets by managers, will create mistrust among outside shareholders and stakeholders and hence limit the firm s ability to conduct market-based contracting. However, because embezzlement by SOE managers implies theft from the government, it will also damage the firm s political networks and hence its ability to contract via these relationships. Consistent with our hypothesis, we find that the stock market reacts more negatively to relationship and mixed scandals than to market scandals. Specifically, while all types of corporate scandals are associated with negative stock returns around the event date (i.e., the first public disclosure of the scandal), the negative returns are more pronounced for scandals that damage relationship-based contracting (i.e., relationship and mixed scandals) than scandals that damage market-based contracting (i.e., market scandals). For example, our univariate analysis finds that during a one-year event window (-6 months to 6 months, with month 0 being the event date), the average cumulative abnormal stock return () is percent for relationship scandals, percent for mixed scandals, and -8.8 percent for market scandals. In our multivariate analysis that further controls for the magnitude of scandals, average stock returns and earnings performance during the three years before the year of the scandals, and several other firm-level, provincial-level, and industry-level variables, we continue to find that relationship and mixed scandals are 5

8 associated with worse stock returns than market scandals. These findings suggest that loss of political networks is more damaging than loss of market credibility, consistent with the view that political connections remain more important than market mechanisms in conducting contracts in China. 5 An important alternative explanation for our results is that the penalties of relationship and mixed scandals may be more severe than the penalties of market scandals. For example, relationship scandals such as bribery may be an excuse of one clique eliminating a competing clique and therefore involve more severe legal sanctions than market scandals. In addition, regulators may penalize firms more for cheating the government than for cheating investors. Consequently, investors would react more negatively when the scandal involves bribery of government officials or misappropriation of state assets, thereby resulting in worse stock returns to relationship scandals and mixed scandals than to market scandals. To address this concern, we perform additional analysis after further controlling for monetary and non-monetary legal penalties imposed on firms and individuals. This analysis finds results continue to support our hypothesis. 6 We also perform several analyses to corroborate our primary findings. First, if relationship and mixed scandals are associated with greater losses in firm value because they damage firms relationship-based contracting ability, we expect relationship and mixed scandals to result in greater loss in firm value among firms with strong 5 As reported in Section 6, the results are not sensitive to several robustness tests, including alternative event windows, alternative treatments of firms that have multiple scandals, alternative stock return measures, alternative treatments of delisted firms, excluding scandals enforced by stock exchanges, restricting firms to those with non-missing data on magnitude of scandals, and restricting firms to SOEs. 6 By controlling for individual penalties, we bias against finding our hypothesized results. This is because the severity of penalties to the offending manager could also proxy for the degree of loss in the firm s political connections and its ability to engage in relationship-based contracting. 6

9 engagement in relationship-based contracting. To test this prediction, we repeat our analysis after partitioning the scandals into strong and weak subsamples based on the strength of a firm s relationship-based contracting. Consistent with our prediction, we find that firms involved with relationship and mixed scandals experience worse stock returns when they have strong engagement in relationship-based contracting. Additional analysis also finds that firms with relationship and mixed scandals experience greater shock to its political networks as reflected in its board structure subsequent to the event than firms with market scandals. We find that firms with relationship and mixed scandals experience greater departure of top executives and directors during the three years subsequent to the event. In addition, both relationship and mixed scandal firms experience higher departure of political and affiliated directors. 7 We also find that relationship and mixed scandal firms appoint more new political directors, suggesting that these firms exert more effort to rebuild their political networks. In addition, while only mixed scandal firms experience a greater net loss of the number of political directors, both relationship and mixed scandal firms experience a higher total turnover (entry and exit) of political directors. Finally, we find that firms with relationship and mixed scandals experience more decreases in loans from state-owned banks than firms with market scandals. In addition, relationship scandal firms have more difficulties in extending their existing loans during the three years subsequent to the event. This result is consistent with our expectation that 7 Interestingly, our analysis does not find a significant difference in the turnover of independent directors between firms with relationship and mixed scandals and firms with market scandals. This is consistent with the notion that independent directors are appointed for professional rather than political reasons. 7

10 relationship and mixed scandals damage political ties that are essential for Chinese listed firms to obtain bank financing (Fan et al., 2008). 8 The paper contributes to the literature in primarily two ways. First, our study is the first to compare the price effects and other economic consequences of scandals that damage relationship-based contracting versus scandals that damage market-based contracting. Prior research on corporate scandals generally focuses on market-based economies such as the U.S. and finds evidence of serious adverse price and economic effects, especially for those scandals related to financial restatements (Karpoff et al., 2008a, 2008b). Among the few studies that focus on corporate scandals in a relationshipbased economy, they generally find evidence of a significant negative price reaction and management turnover to the scandals. For example, Chen et al. (2005) find that enforcement actions of the CSRC (China Securities Regulatory Commission) lead to negative market reactions and increased CEO turnover in China. Our study adds to this literature by providing a comprehensive examination of the different market reactions to and other economic consequences of corporate scandals that damage relationship-based contracting and/or market-based contracting. In addition, to address alternative explanations for our results, we perform analysis including various control variables such as magnitude of the scandals, firm performance prior to the scandals, and the severity of the penalties. By documenting significantly less severe consequences for scandals that damage market-based contracting than for those that damage relationship-based 8 We do not find similar results using government subsidies, perhaps because subsidies are allocated based on pre-determined procedures of the central and local governments. 8

11 contracting in an emerging economy such as China, we add to our understanding on the importance of financial reporting quality and political networks for firms contracting ability in such an economy. Second, our paper complements prior studies on costs and benefits of political ties by shedding light on whether and how the disruption of political ties by corporate scandals impacts firm value. Fisman (1998), Johnson and Mitton (2003), and Leuz and Oberholzer-Gee (2006) document evidence suggesting that political connections bring economic benefits to firms. However, Fan et al. (2007) examine stock return performance subsequent to IPOs in China and provide evidence suggesting that political ties can also impose significant costs on the connected firms, and in equilibrium, the costs outweigh the benefits. Our paper differs from Fan et al. by examining events related to the destruction of political ties and documents that relationship scandals are associated with a decline rather than rise in firm value. Our result suggests that while scandal firms likely still bear the costs from excessive government control and intervention, they have lost their expected benefits from political ties such as state loans or strong trusts from other firms in future contracts. The rest of this paper is organized as follows. Section 2 discusses prior literature and hypothesis development. Section 3 describes the sample and the classification of the scandals. Section 4 presents main empirical results. Section 5 reports additional analysis and Section 6 discusses sensitivity analysis. Section 7 concludes the paper. 9

12 2. Prior literature and hypothesis development 2.1. Prior literature on corporate scandals Corporate scandals are costly to investors and a key concern to regulators worldwide. 9 The vast majority of prior research on corporate scandals focuses on the U.S. due to data availability. Because the U.S. is a market-based setting that relies heavily on arms-length transactions, most of these studies investigate market-based scandals involving financial misrepresentation. These corporate scandals have received heightened attention in the wake of high-profile accounting frauds such as Enron. For example, Karpoff et al. (2008a) find that U.S. firms experience huge losses in firm value if they are involved in accounting manipulation. Karpoff et al. use a sample of U.S. SEC enforcement actions for financial misrepresentation from and document that the market value of the scandal firms drops on average by 38 percent. Their evidence suggests that the price decline is primarily a reputational penalty reflecting the firm s increased difficulty in contracting in the future. In addition, Desai et al. (2006) and Karpoff et al. (2008b) find that senior management involved in the accounting scandals are more likely to be dismissed from the firms. Among the limited studies on corporate scandals in non-u.s. markets, most also focus on market scandals related to financial misrepresentation. For example, Weber et al. (2008) examine the stock and audit market effects associated with the accounting scandal of ComROAD AG in Germany and find that the clients of KPMG (ComROAd s 9 Various countries have passed regulations in response to corporate scandals, including the 1997 Foreign Corrupt Practices Act and the 2002 Sarbanes-Oxley Act in the U.S., the 1998 corporate governance reform in Germany, the 2002 Code of Corporate Governance for Listed Companies in China, and the 2003 corporate law reform in Italy. 10

13 auditor) sustain significant negative abnormal returns during the event periods related to the scandal. Zhang (2007) focuses on the price reaction to the announcement of accounting scandals in China and finds evidence consistent with information spill-over across firms in the same industry. To the best of our knowledge, there has not been any study in the literature that examines corporate scandals that affect firms relationship-based contracting. However, a recent study by Fan et al. (2008), which documents corruption charges against government officials and consequences for the firms connected to these officials, does have implications for corporate scandals that involve the loss of political networks. More specifically, while not a study of corporate scandals per se, Fan et al. examine the changes in financing ability of Chinese listed firms that are connected with high-level (mostly provincial) government bureaucrats suddenly charged with corruption. Fan et al. find that firms lose their ability to raise bank debt when the government officials they bribed or were connected with are charged with corruption. Extending Fan et al. and the above prior studies on market scandals, we intend to use China market, where relationship-based contracting is more prevalent than market-based contracting, and examine if relationship scandals will have a more negative effect on firm value than that of market-scandals Prior literature on political connections Another stream of literature that is closely related to our study is the research on the benefits of political connections. Prior studies find that politically experienced directors are more prevalent among U.S. firms with greater reliance on government-related revenue (Agrawal and Knoeber, 2001). In addition, politically connected directors are 11

14 widespread in countries with poor legal institutions (Faccio, 2006). The prevalence of political connected firms is consistent with the theoretical and empirical work suggesting that these firms can contract more easily with governments and thus receive significant economic benefits, such as government subsidies, state loans, and tax breaks (Fisman, 1998; Johnson and Mitton, 2003; Leuz and Oberholzer-Gee, 2006). However, there is evidence from the prior literature showing that close ties with government will damage firm value as firms and managers rent seek to satisfy political and social objectives (Shleifer and Vishny, 1994). For example, prior studies find that politically connected firms tend to distort their lending decisions during election years, have weaker stock performance, and exhibit poor earnings quality (Dinc, 2005; Fan et al., 2007; Chaney et al, 2011). Fisman (1998) is among the first that uses events that destroy these political connections as a way to measure the value of these connections to the firms. Specifically, he estimates the value of political connections among Indonesian firms using the stock market reaction surrounding the news of President Suharto s worsening health. Our study extends Fisman s approach by focusing on firm specific events i.e. corporate scandals and by using different types of events (scandals) for comparing the value of political connections versus market reputation in contracting Institutional background China, the world s second largest economy as of 2010, has become a major player in international finance. Its three decades of economic reforms have also developed an active capital market, with the total market capitalization of China s domestically listed firms (on the Shanghai and Shenzhen stock exchanges) being second only to that in the 12

15 U.S. as of However, despite this impressive economic growth, China is commonly perceived as a country with weak legal institutions and strong government control of the corporate sector (La Porta et al., 1998; Allen et al., 2005). For example, the Heritage Foundation ranks China among the worst countries in terms of property rights protection in During the rapid capital market development over the past three decades, listed firms in China have often been accused of corporate misconduct such as financial misrepresentation, bribery, and asset misappropriation (Aharony et al., 2000; Chen and Yuan, 2004; Fan et al., 2008). In response, the government has launched a series of market reforms to address these problems. For example, prompted by a string of corporate scandals that emerged in 2001, the CSRC issued the Code of Corporate Governance for Listed Companies in China in 2002, which expanded the rights of minority shareholders, defined the duties of controlling shareholders and corporate boards, and increased information disclosure and transparency requirements. 12 However, despite the significant market reform to facilitate market-based contracting, political networks are still prevalent and crucial to conduct relationship-based contracting 10 See China s stock market: Another great leap (The Economist, August 29, 2009). According to the World Federation of Exchanges, as of 2009 the top three countries in terms of total market capitalization of firms listed in main domestic stock exchanges are: (1) the U.S. with US$ 15 trillion, (2) China with US$ 3.6 trillion, and (3) Japan with US$ 3.3 trillion. 11 Specifically, the 2011 index of economic freedom by the Heritage Foundation ranks China 135 th out of 179 countries. China receives a score of 20 (out of 100) for property rights, based on the following criteria: 20-Private property is weakly protected. The court system is so inefficient and corrupt that outside settlement and arbitration is the norm. Property rights are difficult to enforce. Judicial corruption is extensive. Expropriation is common. 12 See Shi and Weisert (2002) for a summary discussion of these cases and the regulatory reform. The scandals also received highlighted media coverage, including the following: China shares down at noon, hit by Guangxia scandal (Reuters News, September 5, 2001) and Charges are filed in landmark Chinese fraud case Three former executives of a listed store operator accused of hiding losses (The Wall Street Journal, August 7, 2002). 13

16 in China. Due to the strong government intervention in the corporate sector, explicit and implicit contracts based on political networks such as government contracts, state loans, listing rights, equity issuances, government subsidies, operational rights, and other privileges (Faccio, 2006; Faccio et al., 2006) are widespread. In addition, a substantial portion of listed Chinese firms are SOEs in which the government has influence over the appointment of key executives and external auditors, and the firm s ability to obtain state subsidies and loans (DeFond et al., 2000; Fan et al., 2008; Wang et al., 2008; Hung et al., 2012). Even non-state firms need to build connections with the government in order to obtain favors (Lin et al., 1996). Consequently, Chinese firms ability to obtain government contracts depends critically on their political ties rather than merits. Furthermore, in the absence of strong legal and market institutions, most contracts are conducted privately through relationships such as personal ties and internal communications within political networks, rather than market mechanisms using legal procedures and public disclosures Hypothesis Based on the above arguments, we expect the value of relationship-based contracting to be higher than that of market-based contracting in China. This is because in China contracts are primarily conducted based on political relationships rather than market mechanisms. Since relationships within the political networks are more essential for contracting than legal protection and accounting transparency, we predict that scandals that damage relationship-based contracting by severing political ties are more detrimental to firms than scandals that damage market-based contracting by impairing market credibility in China. This leads to the following hypothesis: 14

17 Hypothesis: Corporate scandals that damage relationship-based contracting are associated with greater losses in firm value than corporate scandals that damage marketbased contracting. 3. Sample and classification of corporate scandals 3.1. Sample Our sample includes firms with enforcement actions against their Chairman/CEO by Chinese courts and firms with enforcement actions for financial misrepresentation by securities regulators. We begin our investigation period in 1997 because prior to this period the regulatory disclosure and media coverage of Chinese listed firms was relatively poor. 13 We compile our sample firms and event dates as follows: First, we identify firms with enforcement actions against their Chairman and/or CEO by Chinese local and central courts via news searches. We obtain the key event dates for these scandals from various sources, including 21 st Century Business Herald (for news coverage from ) and online search engines such as and (for news coverage prior to 2001). Second, we identify firms with enforcement actions for financial misrepresentation by the CSRC and stock exchanges using data sources from China Security Market and Accounting Research (CSMAR), China Center for Economic Research (CCER), websites of the 13 The Shenzhen and Shanghai stock exchanges were set up in 1990 and 1991, respectively. The increased media coverage of Chinese firms in 1996 was partly due to the surge in stock prices during that year, which is often referred to as the 1996 Oddity ( China Stock market in a global perspective, Dow Jones Indexes, September 2002). 15

18 CSRC and stock exchanges, and firms annual reports and public announcements. 14 We obtain the key event dates for these firms from the following sources: public announcements by the listed firms, monthly bulletins by the CSRC, public announcements by the Shanghai and Shenzhen stock exchanges, and news reports from The China Securities Journal, Securities Times, Shanghai Securities News, and other major business and finance websites in China. 15 We next obtain stock returns and financial data from the CSMAR database, and CEO and director profiles from the WIND financial database and companies annual reports. Our initial sample consists of 340 firms. For firms with multiple scandals, we keep the most recent ones (deleting 100 prior cases) so our test comprises distinct firms. While using the most recent scandal will likely bias against finding significant market reactions to the scandal (because the market already reacted to the earlier scandal), it ensures that our investigation of governance and financing changes subsequent to the scandal is not confounded by additional scandals. In addition, we delete 24 firms that are subsequently delisted because such firms do not have governance and financing data in periods subsequent to the scandal. While excluding delisted firms is also likely to underestimate 14 We also cross check the data with the list of accounting scandals used in Zhang (2007). We thank Zhang Peng for sharing his data. In addition to financial misrepresentation (i.e., accounting manipulation and false disclosure of financial statement items), the enforcement actions of the CRSC and stock exchanges also include charges related to various other securities violations such as delayed disclosure, market manipulation, or misleading forecasts. To ensure that our sample consists of non-trivial scandals that damage market-based contracting mechanisms, we include only financial misrepresentation because this type of scandal is the common focus of prior studies and most likely to damage firms reporting credibility. 15 We note that Karpoff et al. (2008a) use trigger events (such as self-disclosures of malfeasance, restatements, auditor departures, and unusual trading) as the event date of their accounting frauds sample, and that such dates usually precede the U.S. SEC investigation inquiry. We use the announcement of the investigation inquiry as our event date for the scandals involving accounting manipulation because the trigger events are rare in China. Furthermore, the information media in China is not as well developed as that in the U.S. The announcement of the CSRC or stock exchanges generally is the main public information source on enforcement actions for accounting scandals. 16

19 market reactions to scandals, this approach ensures that there is no major systematic difference between the sample used for our market reactions analysis and the sample used for our governance/financing changes analysis. 16 Finally, we delete four firms that do not have stock return data in CSMAR. These selection criteria result in a final sample of 212 firms Classification of scandals and sample distribution Table 1, Panel A lists the key types of scandals that damage firms ability to conduct relationship-based contracting and market-based contracting. Based on this breakdown, Table 1, Panel B then summarizes the classification of our sample scandals based on the type of contracting ability they destroy: (1) relationship scandals scandals that primarily damage relationship-based contracting but not market-based contracting, (2) mixed scandals scandals that damage both relationship-based and market-based contracting, and (3) market scandals scandals that primarily damage market-based contracting but not relationship-based contracting. Panel A of Table 1 shows that the major types of scandals that damage firms ability to conduct relationship-based contracting are managers bribing government officials (R1) and managers misappropriating state assets (R2), with R2 divided into three subgroups: tax evasion (R2a), managers of SOEs misappropriating firm assets (R2b), and managers of non-soes misappropriating firm assets in which the government has a minority stake (R2c). The R1/R2 scandals potentially damage the firm s political networks in two ways. 16 As reported in Section 6, we also perform sensitivity tests after treating multiple scandals as separate events, keeping only the earliest event for firms with multiple scandals (and deleting all subsequent cases), and adding back delisted firms. Results from these analyses are consistent with those reported in Table 4. 17

20 First, the government will lose trust in the firm s managers and board. Even if the firm replaces the entire management team, it still has to spend time and resources to rebuild its political networks. Second, government officials that accept bribes will also be implicated and hence no longer able to grant favors to the firm. It is important to note that scandals that damage relationship-based contracting (i.e., R1/R2 scandals) do not necessarily harm a firm s outside shareholders or stakeholders (e.g., suppliers or customers). Bribing government officials (R1) to acquire equity issuance rights or obtain government contracts (implicit and explicit) may help channel resources into the firm. In addition, while tax evasion (R2a) may reduce government revenues, it will not directly hurt a firm s outside shareholders or stakeholders. Only misappropriation of firm assets by managers of SOEs (R2b) or by managers of non-soes in which the government holds a minority stake (R2c) will directly hurt a firm s outside shareholders and stakeholders, and thus damage not only firms ability to conduct relationship-based contracting but also market-based contracting. With regards to market-based contracting, Panel A of Table 1 shows that the major types of scandals that damage firms ability to conduct such contracting are financial misrepresentation (M1) and misappropriation of firm assets (M2), with M2 divided into three subgroups: managers of non-soes misappropriating firm assets in which the government has no ownership (M2a), managers of SOEs misappropriating firm assets (M2b), and managers of non-soes misappropriating firm assets in which the government has a minority stake (M2c). The M1/M2 scandals damage firms ability to conduct market-based contracting in two ways. First, because accounting disclosure is critical for outside investors and other stakeholders to make business decisions and enforce 18

21 contracts, misrepresentation negatively affects firms contracting ability with these market participants. Second, because of loss of valuable assets (e.g., through tunneling firm assets) or sub-optimal investment decisions (e.g., in exchange for kickbacks), misappropriation negatively impacts the wealth of shareholders and stakeholders. Note that scandals that damage firms ability to conduct market-based contracting (i.e., M1/M2 scandals) do not necessarily harm the firms ability to engage in relationship-based contracting. Financial misrepresentation (M1) and asset misappropriation by managers of non-soes in which the government has no ownership (M2a) mainly affect market-based contracting. As pointed out in our discussion of R2b and R2c above, only the misappropriation of firm assets by managers of SOEs (M2b) or by managers of non-soes in which the government holds a minority stake (M2c) will damage firms market-based as well as relationship-based contracting ability. Turning to Panel B of Table 1, which presents the classification of our sample scandals based on the type of contracting ability they destroy, we regard misconduct that is a direct offense against the government as primarily damaging relationship-based contracting, while misconduct that is a direct offense against outside shareholders and stakeholders as primarily damaging market-based contracting. Thus, while bribery of government officials (R1) and tax evasion (R2a) in relationship scandals raise doubts in the market about management integrity, we do not classify them as mixed scandals because they are not a direct offense against outside shareholders and stakeholders. Panel B shows that among our 212 sample firms, 26 are relationship scandal firms, 95 are mixed scandal firms, and 91 are market scandal firms. The panel also shows that the most common type of relationship scandal, mixed scandal, and market scandal is managers 19

22 bribing government officials (R1, 24 firms), managers of SOEs misappropriating firm assets (R2b=M2b, 81 firms), and misrepresentation of financial statements (M1, 58 firms), respectively. Appendix A provides examples of relationship, mixed, and market scandals in our sample. Table 2 presents the sample distribution. Panel A of the table reports the sample distribution by year and type of scandal. The table shows an increasing trend in the number of scandals, which likely reflects greater regulatory oversight in the later period. For example, the sharp increase in the number of mixed and market scandals in 2002 is likely due to increased CSRC enforcement actions in response to several high-profile scandals in 2001 (Shi and Weisert, 2002). Panel B of Table 2 presents the sample distribution by industry and type of scandal. The table shows that the manufacturing sector, the biggest sector in Chinese economy, also has the largest number of corporate scandals. 4. Descriptive statistics and empirical results 4.1. Univariate analysis We employ an event study methodology to test market reactions to corporate scandals, with the event date defined as the first public disclosure of the scandal. We measure market reactions using cumulative abnormal returns (s), calculated as stock returns minus returns of the market index on the listing stock exchange during a specified event window. For scandals with enforcement actions against Chairmen/CEOs by courts, we identify the event date as the date in which the press or the firm reports that the executive is arrested or brought in for questioning ( ShuangGui ), whichever is earlier. 20

23 For scandals with enforcement actions by securities regulators, we identify the event date as the date in which the securities regulators or the firm announce the investigation inquiry, whichever is earlier. Figure 1 presents the timeline of the events. While most event studies use a short event window (usually two or three days), we use relatively long event windows (from two months up to two years) for three reasons. First, information leakage is severe in China, especially for charges against Chairmen/CEOs. For example, if a bureaucrat is arrested for accepting bribes from a firm, the market will expect an enforcement action against the executive of the bribing firm. The firm s stock price may therefore already incorporate this information prior to the first public disclosure of the executive s bribery charges. Second, if a firm is temporarily suspended for trading subsequent to the disclosure of the scandal, short event windows will fail to pick up the full price impact of the scandal. 17 Third, while we identify the event date as the first public disclosure of the scandal, the date is generally either the date when the executive s arrest is reported or the date when an investigation inquiry by securities regulators is announced. A long event window will ensure that our results are not driven by the different nature of these event dates. Table 3 presents the market reactions to corporate scandals during various event windows. While we rely on long event windows (from two months up) to draw our conclusions, we report event windows that range from two days to two years surrounding 17 According to Article 157 of the Company Law, the CSRC or Chinese stock exchanges may decide to suspend the trading of stocks for the following reasons: (1) the company's share capital level is below the listing requirement; (2) the company has failed to comply with regulations for public disclosure of its financial situation or has falsified its financial accounting statements; (3) the company is involved in major illegal activities; and (4) the company has incurred losses for the past three consecutive years. Stock trading was suspended for four to six months for eight firms in our sample. 21

24 the event date for completeness. Columns 2, 3, and 4 report mean s for relationship, mixed, and market scandals. These columns show that all types of corporate scandals are associated with negative stock returns during all event windows. Columns 5 and 6 of the panel report the differences in market reactions between scandals that damage relationship-based contracting (relationship and mixed scandals) and the benchmark market scandals. Consistent with our prediction, these columns show that the negative stock returns are more pronounced for scandals that damage relationship-based contracting than those that damage market-based contracting from the two-month window up to the two-year window. For example, looking at the one-year event window (-6 months to 6 months, with month 0 being the event date), we find that the average is percent for relationship scandals and percent for mixed scandals, but only -8.8 percent for market scandals. We note that we do not have predictions on the difference in market reactions between relationship and mixed scandals, the two types of scandals that damage relationship-based contracting. While mixed scandals may be more damaging because they destroy both relationship-based and market-based contracting ability, relationship scandals can be more damaging because they typically also involve charges against government officials overseeing the firm. As shown in Panel B of Table 1, 24 out of the 26 relationship scandals relate to managers bribing government officials. In contrast, only one of the mixed scandals involves charges against government officials. 18 Since the arrest of a connected government official has a direct negative effect on firms political 18 In this case, the manager was charged with both bribing a government official (damages relationshipbased contracting) and accounting manipulation to conceal the bribe (damages market-based contracting). 22

25 networks, relationship scandals can be as damaging as if not more damaging than mixed scandals. Figure 2 plots the average for each type of scandal from one year before the event date to one year after. Consistent with our results in Table 3, the figure shows that all three types of scandals are associated with negative s during the two-year period surrounding the event date. In addition, the decline in firm value is most pronounced for relationship scandals and least pronounced for market scandals Hypothesis test We test our hypothesis by regressing s during event windows from two months up to two years on a dummy variable indicating relationship scandals, a dummy variable indicating mixed scandals, and several control variables. Our model includes the magnitude of the scandal to control for the severity of the scandal. In addition, we control for the following firm characteristics, measured prior to the scandal, that may be associated with market reactions to corporate scandals: firm size, market-to-book, asset tangibility, profitability, stock returns, and a dummy variable indicating whether a firm s majority shareholder is the government. We also include a variable controlling for a firm s provincial legal environment and variables indicating industry membership to control for industry fixed effects. Our regression model is as follows: = β 0 + β 1 (Relationship scandal) + β 2 (Mixed scandal) +β 3 (Magnitude of scandal)+ β 4 (Firm size _pre )+β 5 (Market-to-book _pre ) + β 6 (Tangibility _pre ) + β 7 (Stock return _pre ) +β 8 (ROA _pre ) +β 9 (SOE) + β 10 (Legal environment) + β m (DIndustry) + ε (1) See Appendix B for variable definitions. 23

26 Our hypothesis predicts β 1 and β 2 to be negative. Table 4 reports the results of this analysis. Panel A of the table presents descriptive statistics on the variables used in this analysis. Consistent with our classification that market scandals include financial misrepresentation that materially misstate financial statements, the panel shows that magnitudes of scandals are higher for market scandals than for relationship and mixed scandals. For example, the average magnitude of scandals is 15.72% for market scandals, versus 3.97% and 3.99% for relationship and mixed scandals. 19 The panel also shows that firms involved with market scandals have lower profitability prior to the scandals than firms involved with relationship and mixed scandals. For example, the average ROA _pre is -0.9% for firms involved with market scandals, versus 3.9% and 1.4% for firms involved with relationship and mixed scandals. Panel B of Table 4 presents the regression results. Consistent with our hypothesis, the panel reports that the coefficient on the dummy indicating relationship scandals and the coefficient on the dummy indicating mixed scandals are both significantly negative at p 10% (two-tailed) in all models. Overall, this result indicates that relationship and mixed scandals have worse market reaction than market scandals, suggesting that scandals damaging a firm s relationship-based contracting ability result in greater losses in firm value than scandals damaging a firm s market-based contracting ability Among 212 scandals, we are unable to find information on the magnitudes of scandals for 49 firms (23%). We assume that the magnitudes of scandals for these firms are small and assign a value of zero. To the extent that this assumption introduces measurement errors, we also perform a sensitivity test excluding firms with missing magnitude of scandals in Section 6. This analysis finds our results remain qualitatively the same. 20 We also perform a sensitivity test in which we include a dummy variable indicating a client of a Big Four (or Big Five, before the demise of Arthur Andersen) auditor in our analysis in Table 4. We do not use a dummy variable indicating a Big Ten auditor as in other China studies such as Wang et al. (2008) because the top six to ten auditor rankings changes during our sample period, which makes it difficult to use as a 24