How Do Agency Costs Affect Firm Value? ---Evidence from China

Transcription

1 How Do Agency Costs Affect Firm Value? ---Evidence from China Sheng Xiao * May 2009 Abstract This paper examines the effects of the agency costs on firm value in 156 Chinese publicly listed companies with individual ultimate owners between 2002 and The ultimate owners agency costs, as measured by the divergence between control rights and cash flow rights, are shown to negatively and significantly affect firm value, as measured by the market-to-book ratio of assets (an approximation of Tobin s Q). As the agency costs grow, the stock returns decrease around the connected party transaction announcements, and firms are more likely to engage in value-destroying connected party transactions. These effects are particularly strong for some types of connected party transactions, notably loan guarantees and direct fund transfers. Further, as the agency costs grow, the firms violate laws more frequently and the nature of legal violations becomes more severe. Evidence from an exogenous policy shock, the non-tradable share reform confirms that higher agency costs cause more unfavorable stock market reactions to connected party transaction announcements. Key words: Corporate governance, ultimate control, agency costs, connected party transactions, fraud, firm performance JEL Classification Number: G32, G34 * Sheng Xiao is the Red Hughes Chair Visiting Assistant Professor at Furman University in Greenville, SC, USA. I have benefitted from my discussions with Sean Chen, Peter L. Rousseau, Thomas Smythe, Cong Wang, Yan Wang,Tina Yang, Tong Yu, Shan Zhao and seminar participants at Emory University, Furman University and Minnesota University. I would like to thank President Peng Xiong and Mr. Degan Yu of SinoFin Information Services for their great assistance for my data collection. I would like to thank Linqiang Huang for his outstanding research assistance. All errors are my own. Tel: ; shengxiao2006@gmail.com.

2 1. Introduction The separation of ownership and control in modern corporations gives rise to agency costs. Specifically, in the US and UK, where dispersed ownership is the norm, these agency costs mainly arise from the agency conflicts between dispersed shareholders and the powerful management teams, while in the rest of the world, where concentrated ownership is prevalent, such agency costs mainly originate from the agency conflicts between controlling shareholders and minority shareholders. 2 Recent research generates important insights into the latter type of agency costs. Classens et al. (2000) identify the pyramid structure and cross-holding as firms major organizational forms to separate their ownership and control in eight East Asian economies 3. They measure the agency costs by the divergence between the ultimate owner s cash flow rights and control rights 4. Ever since then, their methodology of agency costs measurement has been used extensively. For example, Classens et al. (2002), Lemmon and Lins (2003), and Lins (2003) use this methodology to examine the impact of agency costs on firm value in emerging economies. They conclude that in general, the divergence between the ultimate owner s cash flow rights and control rights has negative and significant impact on firm value, as measured by the market-to-book ratio of assets (an approximation of Tobin s Q). An important question that naturally arises from these impactful studies is: what accounts for this negative relationship? In other words, what are the channels through which the agency costs 2 La Porta et al. (1999), Claessens et al. (2000), and Faccio and Lang (2002). 3 These economies are: Hong Kong, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. 4 See Figure 1 for an example of this measurement methodology. 1

3 negatively affect firm performance? Masulis et al. (2008) pioneer in disentangling this black box in the relationship between the agency costs and firm performance. They analyze the agency costs in U.S. dual-class companies and conclude that as the divergence widens at dual-class companies, corporate cash holdings are worth less to outside shareholders, CEOs receive higher levels of compensation, managers are more likely to make shareholder-value destroying acquisitions, and capital expenditures contribute less to shareholder value. These findings support the hypothesis that managers with greater control rights in excess of cash-flow rights are prone to waste corporate resources to pursue private benefits at the expense of shareholders. As La Porta et al. (1999) indicate, pyramids and multiple classes of stock are two major ways of separating cash flow and control rights in firms. While Masulis et al. (2008) disentangles the negative relationship between the divergence of cash flow rights and control rights and firm performance in dual-class companies, this paper focuses on such a relationship in firms with pyramid structures, the dominant ownership structure in many countries around the world 5. Motivated by the conjecture of Faccio et al. (2001, p.55) that, in pyramid structures, corporate wealth can then be expropriated by the insiders who set unfair terms for intragroup sales of goods and services and transfers of assets and control stakes, this paper analyzes the impact of agency costs on firms connected party transactions. Studying over 600 connected 5 See Figure 1 for an example of the pyramid structures in mainland China. For pyramid structures in Asian economies other than mainland China, see Claessens et al. (2000). For pyramid structures in Europe, see Faccio and Lang (2002). 2

4 party transactions in a balanced sample (936 firm-year observations) from 156 publicly listed companies with individual ultimate owners between 2002 and 2007, this paper shows that as the agency costs grow, the stock returns decrease around the announcements of the connected party transactions, and managers are more likely to engage in value-destroying connected party transactions. These effects are particularly strong for some types of connected party transactions, notably loan guarantees and direct fund transfers. These results validate the hypothesis that agency costs reduce firm value through connected party transactions. One drawback of the study of connected party transactions is that not all connected party transactions have been disclosed, and many of the tunneling activities are hidden until the legal violations are prosecuted. This motivates me to examine the public record of legal violations of the firms. I find that the greater the divergence between the ultimate owner s control rights and cash flow rights, the more frequent and severe the legal violations are. This evidence complements the results from the study of connected party transactions and confirms the hypothesis that the agency costs diminish firm value by increasing the frequency and severity of legal violations. This paper makes three major contributions: (1) While former papers mainly focus on the divergence between the cash flow rights and control rights in the US (mainly through dual-class shares) or emerging economies (not including China) (mainly through the pyramid structures and cross-holdings), this paper examines the impact of such divergence in companies with 3

5 individual ultimate owners in China. In the past three decades, China has gone through arguably the most profound economic transformation from a near 100% state-owned centrally-planned economy in 1978 to a decentralized market economy with (2/3) of its GDP being produced by the private sector currently 6. The size of the Chinese economy in 2007, as measured by the nominal GDP, was about 40% larger than the combined GDP of the eight economies examined by Claessens et al. (2000) and Claessens et al. (2002), which implies that the size of the private economy in China nowadays roughly equals the combined GDP of the eight economies examined by Claessens et al. (2000) and Claessens et al. (2002). 7 Figure 2 shows that between 2002 and 2007, the proportion of listed companies with individual ultimate owners among all publicly listed companies in China almost doubled from 18% to 34%, attesting to the increasing significance of those companies. Former studies about Chinese firms focus mainly on the agency costs in the state-owned enterprises (SOEs) in China. Those agency costs mainly stem from the different objectives of the government and the firms 8. In contrast with those papers, to 6 See Sun and Tong (2003) and Rousseau and Xiao (2008) for more details on the share issue privatization in the Chinese economy. 7 Specifically, the nominal GDP of China, as reported by the CIA (2008), was 3,251,000 million USD, while in the same year, the sum of the nominal GDP of the eight Asian economies as in Claessens et al. (2000) and Claessens et al. (2002) adds up to 2,334,300 USD. (This computation leaves out the GDP of Taiwan because Taiwan s GDP is not available in the CIA database.) 8 For example, Lin et al. (1998) argue the policy burdens of Chinese state-owned enterprises (SOEs) accounted for the bad performance of those firms. Fan et al. (2007) show the negative effects of political connections on the board professionalism and firm performance of SOEs in China. In SOEs, managers may gain political support by pursuing full employment policies at the expense of profits, and may apply soft 4

6 the best of my knowledge, this is the first paper that focuses exclusively on the agency costs of Chinese firms with individual ultimate owners. Hence, this study enriches the literature and provides internationally comparable results, since the vast majority of publicly listed firms in countries around the world are owned by individual, instead of the State, ultimate owners, as concluded by La Porta et al., (1999), Claessens et al. (2000) and Faccio and Lang (2002) 9. (2) This paper uses the most up-to-date data to successfully identify the negative relationship between the agency costs and the stock market reactions to connected party transaction announcements. Thus, this paper identifies an important channel through which the agency costs affect firm performance with the latest evidence. 10 (3) This paper shows that the agency costs lead to more frequent and severe budget constraints that end up not binding due to bailouts of the State (Kornai 1979). These distortions can result in redundant employees (Shleifer and Vishny 1994, Boycko et al. 1996), employment of politically connected individuals rather than the best-qualified (Krueger 1990), poor choices of product and location, and investment in projects with low net present values. See Rousseau and Xiao (2007) for a game-theoretical model to illustrate the effects of the objective functions of the government and the firms on firm performance. 9 La Porta et al. (1999) report that using 20% as the cutoff value for the control rights, on average, 30% of firms in their sample of 27 countries have private ultimate owners, versus 18% of firms in their sample with State ultimate owners. Analysis based on other control rights cutoff values and firm classifications (for example, firm size) generates qualitatively similar results for comparison purpose. Compared with La Porta et al. (1999), Claessens et al. (2000) s study of East Asian companies (excluding Chinese companies) and Faccio and Lang (2002) s study of Western European companies reveal even wider gaps between the two proportions (the proportion of companies with private ultimate owners and the proportion of companies with state ultimate owners). 10 Fan and Wong (2002) and Haw et al. (2004) identify earnings management and income management as important channels through which the agency costs affect firm performance. 5

7 legal violations an explicit manifestation of the negative impact of the agency costs on the corporate decision making. The remainder of the paper is organized as follows: section 2 reviews the related literature, section 3 describes the data, section 4 explains the empirical methodology and reports the results, and section 5 concludes. 2.Literature Review Johnson et al. (2000) coin the word tunneling in corporate governance. They define tunneling as the transfer of resources out of a company to its controlling shareholder. They propose some channels of tunneling, for example, asset sales, contracts such as transfer pricing advantageous to the controlling shareholder, excessive executive compensation, loan guarantees, expropriation of corporate opportunities, and so on. Inspired by Johnson et al. (2000) s original idea, Cheung et al. (2006) carefully analyze 375 connected party transactions in Hong Kong during , and conclude that firms announcing connected party transactions indeed earn significant negative excess returns, and investors cannot predict expropriation because there is only limited evidence that firms undertaking connected party transactions trade at a discounted valuation. However, this important study has detected no identifiable impact of the agency costs, as measured by the divergence between cash flow rights and control rights, on the stock market s reaction to connected party transactions. In contrast with Cheung et al. (2006), this paper shows that the wider the 6

8 divergence between the ultimate owner s cash flow rights and control rights, the lower the stock returns around the connected party transactions announcements, and the firms are more likely to engage in value-destroying connected party transactions. These results are particularly true for some types of connected party transactions, notably loan guarantees and direct fund transfers 11. Berkman et al. (2009) compare 88 Chinese listed firms that provided loan guarantees with 787 Chinese listed firms that did not in They conclude that firms issuing loan guarantees to one of their block holders have significantly lower returns on assets, significantly lower dividend yields, significantly higher leverage, and significantly lower values of Tobin s Q. (p. 151). Their results from the comparisons between firms issuing loan guarantees and not issuing loan guarantees are consistent with my results in this paper, which directly examines the effects of the agency costs on the stock returns around the announcements of the connected party transactions in a balanced panel of 156 listed firms with individual ultimate owners from 2002 and This paper also shows that, in contrast with Cheung et al. (2006) s results for connected party transactions in Hong Kong, it seems that in mainland China, people do predict the connected party transactions because the cumulative abnormal return drops significantly starting from 11 Some researchers have also examined connected party transactions other than loan guarantees and direct fund transfers. For example, Deng, Gan and He (2008) study 295 SOEs that were partially privatized between 1997 and 2000 and focus on transfer pricing through goods and services, sales of assets, and trade credit. They conclude that for firms with incomplete restructuring, whereby the most productive part of the firms was carved out for public listing, leaving the parent SOEs to keep all the policy burdens under state ownership, the parent SOEs have strong incentives to transfer resources from the listed companies to them through connected party transactions, causing underperformance of the listed companies. As mentioned in the previous section, in contrast with their paper, this paper focuses on the publicly listed companies with individual ultimate owners. 7

9 10 trading days before the announcement date (see the results for window [-10, +1] in Tables III and IV). This information leakage might result from generally weak corporate governance of those firms. Connected party transactions may not fully capture the negative impact of the agency costs, because some tunneling activities are not disclosed until those illegal activities are prosecuted. To fully gauge the impact of agency costs, this paper continues to examine how agency costs affect the frequency and severity of legal violations. Chen et al. (2006) s analysis of 169 legal violations of China s listed companies during concludes that while the boardroom characteristics are a factor in explaining fraud, the ownership patterns appear to be unimportant. In contrast, this paper shows that the divergence between the cash flow rights and control rights of the ultimate owner is positively and significantly related to the frequency and severity of legal violations of Chinese firms. Thus, different from Chen et al. (2006), I find that the agency costs generated by the ownership structures indeed result in more frequent and severe legal violations in China Data The data come from a series of datasets developed by the SinoFin Information Services of the China Center for Economic Research (CCER) at Beijing University: the Database of Chinese Listed Firms with Private Ultimate Owners (2008), the 12 The different results mainly originate from the different focuses of this paper and Chen et al. (2006) in that the latter focuses on the immediate ownership types (State, Legal Person, etc.) while this paper focuses on the ultimate ownership structures of individually-controlled enterprises. 8

10 Chinese Listed Firm Annual Report Database (2008), the Chinese Stock Return Database (2008), the Chinese Stock Market Index Return Database (2008), the Chinese Listed Company Connected Party Transactions Database (2008), and the Chinese Listed Company Legal Violation Database (2008). To be included in the Chinese Listed Private Firms Database (2008), the ultimate owner of the Chinese publicly listed firm must be an individual (or a group of individuals). Since 2002, all Chinese listed firms have been required by the CSRC (China Securities Regulatory Commission) to report their ultimate owners as well as the control chains in their annual reports. The CSRC defines the ultimate owner of a publicly listed company as: (1) the largest shareholder; or (2) the shareholder with a greater voting power than the largest shareholder; or (3) the shareholder with shareholding or voting rights above 30% of the total shares or voting rights in the company; or (4) the shareholder who can determine over half of the board members. This database includes those firms detailed ownership structure and corporate governance information directly from the annual reports. The database defines independent board members as the board members who neither serve any other roles (besides being board members) in the company nor have any relationship with the company or its major shareholders that may hinder the board members objective decision-making. Figure 3 shows how these companies went public and how their ultimate owners control them. Specifically, in 2002, among all publicly listed companies with individual ultimate owners, 68% went public through IPOs while 32% went public through the mergers and acquisitions of existing publicly listed 9

11 companies ( reverse takeover ). In 2007, 53% went public through IPOs while 47% went public through reverse takeover. This may be because over time, more and more firms with individual ultimate owners intended to bypass the lengthy, costly and complex process of the IPO. This figure also shows that in 2002, among all publicly listed companies with individual ultimate owners, 98% had pyramid ownership structures, while in 2007, 87% had pyramid ownership structures. The downward trend in that proportion over the years between 2002 and 2007 seems obvious. The Database of Chinese Listed Firms with Private Ultimate Owners (2008) defines the cash flows rights and control rights of the ultimate owners in the same way as in Claessens et al. (2000), Claessens et al. (2002), and Faccio and Lang (2002). The cash flow rights are measured by the sum of the products of the proportions of ownership along the control chains, while the control rights are measured by the sum of the minimum proportions of ownership along the control chains. For a specific example, please see Figure 1. To measure the agency costs of ultimate owners, I compute the divergence between the cash flow rights and control rights in two ways: (1) the wedge, which is computed by subtracting the cash flow rights from the control rights; (2) the ratio, which is computed by dividing the control rights by the cash flow rights (the same as the cash flow rights leverage in Lemmon and Lins (2003)). Figure 4 shows that between 2002 and 2007, the average cash flow rights ( Cash ) of the ultimate owners increased steadily from 21% to 24.83%, while their average control rights ( Control ) increased from 32.41% to 33.46%. Over the same period, the wedge between control rights and cash flow rights decreased from 11.42% 10

12 to 8.64% on average, and the ratio between the control rights and cash flow rights decreased from 2.17 to 1.85 on average---a reduction in the agency costs that may result from improvements in corporate governance. Figure 5 shows that between 2002 and 2007, the average proportion of independent directors (IDR) rose from 26% to 37%. The average board size decreased from 9.19 to These changes are generally consistent with the view that corporate governance has improved over the years for those firms. On average, around 13%-17% of board directors hold shares of the publicly listed companies (BNUM). Intererestingly, on average, a board chairman holds more shares of the company than the CEO for any given year in the sample, and the gap seems to be growing. For example, in 2007, the board chairman hold on average 4.3% of the shares ( BSHARE ), while the CEO only holds 1.8% of the shares on average ( CEOSHARE ).) Following Claessens et al. (2000, page 91), this paper reports results for ultimate owners that control at least 5% of the votes, as this cutoff value of control rights would allow the largest sample possible, but I have also tried to raise this cutoff value to 10% and 20% (as in La Porta et al. (1999)), and the results are qualitatively similar (the results with cutoff values of 10% and 20% are available upon request). The Chinese Listed Firm Annual Report Database (2008) reports the market-to-book ratio of assets as the (equity market value+liabilities book value)/total assets, an approximation of Tobin s Q that has been widely used to measure firm value. In view of the notorious non-tradability issue of Chinese shares and the controversial discount rate that should be applied to the value of non-tradable shares, 11

13 this database computes the equity market value in the following way: equity market value=tradable share value+the value of net assets represented by non-tradable shares. I define leverage as total debt/total assets. Given the fact that the variations in the market-to-book ratio of assets may be cyclical, I collect nominal per capita GDP and CPI data from the China Statistical Yearbook 2008 (National Statistics Bureau of China) and compute the real per capita GDP in 2002 prices from these data. The Chinese Stock Return Database (2008) and the Chinese Stock Market Index Return Database (2008) record daily stock returns for individual stocks and for stock market indexes. Similar to Cheung et al. (2006) and Fan et al. (2007), this paper defines abnormal returns as the market-adjusted stock return, i.e., abnormal return=individual stock return-shanghai stock index return 13. The cumulative abnormal return is the sum of daily abnormal returns over the event windows. The Chinese Listed Company Connected Party Transactions Database (2008) records the announcement dates, types and amounts of the connected party transactions for listed companies in China. In 1997, the Treasury Ministry of China promulgated the first set of accounting rules governing connected party transactions in China in Accounting Rules on the Disclosure of Connected Party Relationship and Transactions (hereafter referred to as 1997 Rules). This document states that if one party can control or exert significant influence on another party, or both/all parties are controlled by the same third party, then these parties shall be regarded as connected 13 Cheung et al. (2006) and Fan et al. (2007) use a similar method to compute the CAR for listed firms in Hong Kong and mainland China, respectively. Shanghai stock index is a market-value-weighted index. 12

14 parties. Here, control refers to the decisive power to determine the financial and operational decisions of a company, and exerting significant influence refers to the power to participate in the decision-making process of a company, but not the decisive power. Examples of exerting significant influence include the board representation and management team involvement. The 1997 Rules states that all transfers of resources or liabilities between the connected parties, no matter whether there is any quid pro quo, shall be regarded as connected party transactions. Further, all connected party transactions shall be disclosed. In 2001, CSRC started to require that significant connected party transactions, defined as over 3 million yuan in the amount or over 5% of the company s net asset value, shall first be approved by the company s independent directors and then proposed to the board (hereafter referred to as 2001 Rules). The Chinese Listed Company Legal Violation Database (2008) records the legal violations of Chinese publicly listed companies and the law enforcement by the CSRC. There are four types of law enforcement, corresponding with different levels of severity of the legal violation: (1) to file a case and start investigation; (2) public denunciation; (3) public criticism; (4) public law enforcement (e.g., imposing a fine or arresting the CEO). The severity of the legal violation increases from (1) to (4). This paper defines the variable legal violation as 0 if there is no legal violation, and if there is a legal violation, the variable legal violation will take the values of 1, 2, 3 or 4, based on the above classification. To clean the data and finalize the sample for study, I delete the abnormal 13

15 observations with Return on Assets that exceeds 1. To ensure that my results are not driven by firms entering and leaving the samples, I include only firms that existed in the databases for the entire period of 2002 and The resulting sample consists of 156 firms with 936 firm-year observations. To the best of my knowledge, this is the largest balanced sample for Chinese publicly listed firms with individual ultimate owners available to me. Figure 6 illustrates the industrial distribution of the sample firms. A majority (53%) of the sample firms are in the manufacturing industry, 16% of the sample firms are classified as Comprehensive, and 11% of the sample firms are in the Information Technology (IT) industry. None of the sample firms are in the financial services industry or regulated utilities industry. Table I shows the summary statistics of the sample. The mean wedge between the control rights and cash flow rights is percentage points, and the mean ratio between the control rights and cash flow rights is Methodology and Empirical results 4.1. The agency costs and firm value My analysis starts with an examination of the relationship between the agency costs and firm value. The agency costs are measured by the divergence between the ultimate owner s control rights and cash flow rights, and the firm value is measured by the market-to-book ratio of assets 15. Panel regressions are estimated for the 14 Chhaochharia and Grinstein (2009) use the same data selection criterion. 15 This measure of the firm value is the same as in Claessens et al. (2002). It is an approximation of Tobin s Q. 14

16 following specification: MB jt = jt β 0 + β1divergencejt + B' X + ε (1) In this regression, Divergence is measured by the wedge (control rights minus cash flow rights) or ratio (control rights over cash flow rights) of the ultimate owners, X is a vector of control variables, and B is the coefficient vector for these control variables. The control variables include firm size, firm leverage, the cash flow rights of the ultimate owners, the shares owned by foreign investors, the ratio of independent directors on the board, the size of the board, and real per capita GDP (to control for macroeconomic fluctuations). The firm Size is measured by log(assets), Leverage is measured by total debt/total assets, Cash refers to the cash flow rights of the ultimate owners 16, Foreign refers to the proportion of shares owned by foreign investors, and GDP is the logarithm of the real per capita GDP in 2002 prices. Firm size is a control variable that may generate economies of scale that boost firm value, or generate coordination and management problems that may lower firm value. Leverage is a control variable that is expected to generate financial distress and bankruptcy risks for the firms, especially for the firms in our sample, which are owned by individual ultimate owners and receive much weaker financial support than the State-Owned Enterprises (SOEs). The ultimate owner s cash flow rights are included in the regression to account for their expected positive incentive effects on firm performance, as Claessens et al. (2002) and Joh (2003) explain. The ratio of independent directors and the board size have been shown to have significant impact 16 This measure is termed ownership concentration by Joh (2003). 15

17 on firm decision-making and performance in the literature 17, so I include these variables to encompass the effects of the boards on firm value. Table II reports the results of the random-effects models and firm fixed-effects models. 18 It shows similar results as in Claessens et al. (2002). The agency costs indeed have a negative and significant impact on firm value in China. Therefore, such results are not restricted to the eight emerging markets that Claessens et al. (2002) examine. In the sub-samples of the following sub-sections, this negative and significant relationship between the agency costs and firm value has been proven to be robust (unreported in this paper but available upon request). In addition, larger firms seem to have lower firm value. Unsurprisingly, the market-to-book ratio of assets is indeed cyclical, as it is positively associated with real per capita GDP. Surprisingly, the cash flow rights of ultimate owners have a negative and significant impact on firm value, which appears to be at odds with Claessens et al. (2002) s results regarding the incentive effects of large shareholders. The effects of foreign investors shareholdings seem to be insignificant in the random effect models and significantly negative in the fixed effect models. At first glance, these results may suggest that foreigners investment has not boosted firm value, but this result may also be driven by the small number of companies with foreign investors (only 14 firms in the sample 17 See Rosenstein and Wyatt (1990), Choi, Park and Yoo (2007), and Chhaochharia and Grinstein (2009) for the significant effects of board independence on firm behavior and performance, and see Yermack (1996) and Coles et al. (2008) for the significant effects of the board size on firm performance. 18 The firm fixed-effects models are used to control for any unobservable fixed firm characteristics that can affect firm value. 16

18 have foreign investors). Therefore, this result should be taken with great caution The agency costs and connected party transactions To investigate the relationship between the agency costs and the market-adjusted CAR around the connected party transactions announcements, I use the following framework: CAR = β 0 + β1wedge + B' X + ε (2) This regression uses the wedge instead of the ratio between the ultimate owner s control rights and cash flow rights to measure the agency costs, because as Joh (2003, p.298) indicates, a leverage ratio can distort the degree of the control-ownership disparity when ownership is very low or very high. The control variable vector X are the same as in equation (1). Table III reports the OLS regression results for the above specification. In all the event windows, the divergence between control rights and cash flow rights exert negative and significant impact on the market-adjusted cumulative abnormal returns (CAR). The effect of the divergence is economically significant. A one standard deviation (9.71 percentage points, as in Table 1) increase in the wedge will lead to about 1 percentage point reduction in CAR, which translates into an average loss in the equity value of 8.68 million yuan for each firm (based on the average equity value of 868 million yuan for the firms in the sample over ) Similar to Cheung et 19 A salient feature of Chinese publicly listed companies with individual ultimate owners is that quite a few of them register investment companies in tax havens like Cayman, Bermuda, or the British Virgin Islands, and then re-invest in their publicly listed companies with foreign investor identities. So the real identities of foreign investors seem unclear. See Chernykh (2008) for the illustration of a similar phenomenon in Russia, and Huang (2008) for a detail description of so-called round-trip FDI in China. 17

19 al. (2006), the cash flow rights of the ultimate owner negatively and significantly affect the market-adjusted CAR, while neither the ratio of the independent directors on the board nor the relative size of the connected party transactions (the amount of the connected party transactions/the total asset of the firm) has any significant effect on the market-adjusted CAR. 20 The leverage ratio seems to have negative effects on the CAR, as investors may be well aware of the risks of financial distress and bankruptcy associated with higher debt levels, especially for companies with individual, instead of the State ultimate owners. Table IV reports the results regarding the agency costs and the cumulative abnormal returns around the announcement of some specific connected party transactions. Among all connected party transactions, two types of connected party transactions are found to involve tunneling most: (1) the listed company and the connected party provide loan guarantees or collaterals for each other; (2) the listed company and the connected party transfer funds to each other. For example, Wang and Yang (2007, page 57) s research shows that in 2005, the above types of connected party transactions reached a staggering total amount of 1 trillion yuan (about billion USD). Wang and Yang (2007, page 93) report that, a survey in 2004 organized by the Shanghai Stock Exchange shows, when the above types of connected party transactions occur to a listed company, 77.05% of stock investors will consider selling the shares of that company, 18.53% of stock investors will consider resorting to legal 20 Cheung et al. (2006) also find statistically significant and negative relationship between main shareholder ownership and market-adjusted CAR. They find no statistically significant relationship between proportion of independent non-executive directors and market-adjusted CAR, and no statistically significant relationship between transaction value over total market value and market-adjusted CAR. 18

20 means to protect their interests, and 91.29% of stock investors list the existence of the above types of connected party transactions as one of the most important factors when considering investment in the company. Consistent with the above anecdotal evidence, Table IV reports that for these connected party transactions, using the [-10,+1] window and according to the parsimonious specification in the third column of the table, a one-standard deviation increase in the wedge (9.71 percentage points, as in Table 1) will lead to about a 2-percentage-point loss in the CAR, which translates into an average loss of million yuan in the equity value for each firm (based on the average equity value of 868 million yuan for the firms in the sample over ) Both Tables III and IV show the information leakage before the announcement of the connected party transactions, as the event window [-10,+1] shows significantly lower CARs associated with higher agency costs. Table IV also shows that the ratio of independent board members seems to show positive and significant effects on the CAR in [-2, +2] and [0,+5] event windows. The expected monitoring role of independent directors, as in 2001 Rules (see section 3) seems to be realized for these specific connected party transactions. Table IV reveals that leverage is negatively and significantly related to the market-adjusted CAR, as investors respond negatively to loan guarantee and direct fund transfer announcements of those firms laden with debt. The results in Tables III and IV show that connected party transactions made by companies with more control rights than cash-flow rights generate lower announcement-period abnormal returns, but it is not clear whether these connected 19

21 party transactions tend to generate negative abnormal returns and destroy shareholder value. To tackle this issue, I estimate a logit model in which the dependent variable is equal to one if the announcement-period CAR is negative and zero otherwise as follows, where X is a vector of control variables similar to those in equations (1) and (2) in a more parsimonious specification (some insignificant control variables in equations (1) and (2) have been dropped out): D = β 0 + β1wedge + B' X + ε (3) Table V shows that the higher the agency costs, the more likely that the firm will engage in value-destroying connected party transactions, especially loan guarantees and direct fund transfers. Specifically, a one-standard-deviation increase in the divergence between the cash flow rights and control rights ( wedge ) leads to a percentage point increase in the likelihood of engaging in value-destroying connected party transactions, and a percentage point increase in the likelihood of engaging in value-destroying connected party loan guarantees and direct fund transfers. A case in point to illustrate the devastating effects of connected party transactions on firm performance would be Monkey King Co. Ltd (stock code: ). As one of the earliest IPO firms in China, Monkey King Co. Ltd. had its IPO in 1993, went bankrupt in 2002, and got de-listed from Shenzhen Stock Exchange in A major cause of its failure was providing extensive bank loan guarantees and funds to its controlling shareholder, Monkey King Group, in the staggering amount of RMB 1 billion, which equaled 123% of Monkey King Co. Ltd s total assets in Data source: page 104, Classical Cases in Capital Management in China (Xu 2005). 20

22 In 2001, Monkey King Group went bankrupt. As a result, the loans that Monkey King Co. Ltd. and banks provided to Monkey King Group turned sour. Consequently, Monkey King Co. Ltd. was forced to go bankrupt because of its huge amount of connected party transactions with Monkey King Group The agency costs and legal violations To investigate the relationship between the agency costs and legal violations of the firm, I use the following Poisson regression: Legal violation= β 0 + β1divergence + B' X + ε where Divergence is measured by the wedge or ratio between the control rights and cash flow rights. X is the vector of control variables, and B is the vector of coefficients for the control variables. Please see the Appendix for a detailed description of the control variables. Results in Table VI show that the higher the agency costs, the more frequent and severe are the legal violations. Larger firms and worse-performing firms seem to violate laws more often and more severely. It appears that the higher the proportion of foreign shares, the more frequent and severe the legal violations are. This result may be caused by the small number of firms in the sample with foreign shares, and may be because of the round-trip FDI (domestic investment disguised as FDI) as described in footnote 19, and should therefore be treated with caution. Firms with larger boards violate laws more frequently and severely, echoing Yermack (1996) s results regarding higher market valuation of companies with a 22 As a side note, Monkey King Co. Ltd. was initially a state-owned enterprise, but it went through privatization in 1997, and the largest shareholder switched from the State to Monkey King Group, which was controlled by private ultimate owners. 21

23 small board of directors. Many legal violations directly originate from the undisclosed value-destroying connected party transactions, especially loan guarantees and direct fund transfers. A case in point is again the Monkey King Group. In 2000, Shenzhen Stock Exchange openly denounced Monkey King Co. Ltd. for its failure to disclose in time the large amounts of loan guarantees and direct funding provided to its controlling shareholder, Monkey King Group. Another salient example is the business empire of Mr. Zhongbao Qiu, consisting of three publicly listed companies (together with some un-listed companies). The ultimate controller, Mr. Zhongbao Qiu, tunneled a staggering 1.48 billion yuan (about 185 million USD) through direct fund transfers and 907 million yuan (about 113 million USD) through loan guarantees from these three publicly listed companies. Figure 7 illustrates the basic structure of Mr. Qiu s business empire. The illegally enriched Mr. Qiu frequently appeared in casinos in Macao, Las Vegas, Malaysia, etc. He was arrested on February 25, 2006 and was sentenced to 20 years in prison plus a fine of one million yuan (about 125 thousand USD) in November Endogeneity Evidence in section 4.2. shows that the wedge between control rights and cash flow rights is negatively and significantly correlated with the stock markets reactions to connected party transactions. This correlation may imply both directions of causality, i.e., the wedge may cause unfavorable stock market reactions to connected party transactions, or the unfavorable stock market reactions may lead to even wider 22

24 wedge, as the ultimate controllers may have to adjust their ownership structure to maintain their original levels of expropriation of minority shareholders. To investigate this endogeneity issue, I examine an exogenous policy reform that changed the divergence between control rights and cash flow rights. This exogenous policy reform was the non-tradable share reform. In May 2005, China Securities Regulatory Commission, the counterpart of SEC in China, initiated a non-tradable share reform, aiming at converting the non-tradable shares in listed firms to tradable shares. Such a reform was expected to reduce the ultimate owners incentives to expropriate minority shareholders because the ultimate owners cash flow rights would be increased with the enhanced tradability of shares. Therefore, I hypothesize that after the non-tradable share reform, the divergence between ultimate owners cash flow rights and control rights would have a negative, but smaller impact on the stock markets reaction to connected party transactions. To test this hypothesis, I collect the announcement dates of non-tradable share reform for each company in the sample from the Non-tradable Share Reform Database developed by Sinofin Information Services, and estimate the following regression: CAR = β + β Wedge + β Wedge * Dummy + B' X + ε where Dummy equals one if the connected party transactions occur after the non-tradable share reform and zero otherwise, wedge is the ultimate owner s control rights minus cash flow rights, X is the vector of control variables as in Tables III and IV. If my hypothesis is correct, then I would expect β1 to be negative, 23

25 β2 to be positive, and β 1 + β 2 to be negative. Table VII reports the results for loan guarantees and direct fund transfers, the particular types of connected party transactions that may be most likely to destroy firm value (as section 4.2. shows). The results support my hypothesis, and are consistent with the view that a larger wedge between the ultimate owner s control rights and cash flow rights will cause greater losses in firm value when connected party transactions are announced. 5. Conclusion Following Claessens et al. (2000) and Claessens et al. (2002) s path-breaking studies on the relationship between the divergence of control rights and cash flow rights and firm value in East Asian countries, this paper extends their research to a sample of 936 firm-year observations for 156 Chinese publicly-listed companies between 2002 and These companies all have individual ultimate owners, thus the results from this study are readily comparable to results from other market economies. This paper finds that the divergence of control rights and cash flow rights indeed leads to lower firm value, thus confirming the generality of Claessens et al. s (2002) results in the Chinese context. This paper further explores what accounts for this negative relationship. Specifically, this paper focuses on the impact of such agency costs, measured by the divergence between the cash flow rights and control rights, on the valuation effects of firms connected party transactions. My analysis shows that as the agency costs grow, 24

26 the stock returns decrease around the announcements of the connected party transactions, and firms are more likely to engage in value-destroying connected party transactions. These effects are particularly strong for some types of connected party transactions, notably loan guarantees and direct fund transfers. Further, the higher the agency costs, the more frequent and severe the legal violations will be. Results from an exogenous policy shock: the non-tradable share reform confirm that larger divergence between control rights and cash flow rights causes more unfavorable stock market responses to loan guarantee or direct fund transfer announcements. Thus, this paper identifies some important channels through which the agency costs affect firm value. During the period , it seems that the corporate governance of Chinese publicly listed firms with individual ultimate owners has improved. Figure 3 illustrates a steady decline in the proportion of those firms with the pyramid structures. This trend is expected to reduce those firms agency costs and enhance the firm values. Figure 4 reinforces this conclusion by showing that on average, the agency costs, as measured by the wedge or ratio between the control rights and cash flow rights, have indeed fallen during this period. Figure 5 shows that the average ratio of independent directors on the board has increased steadily, so the monitoring role of the board may have been further strengthened, which may lead to higher firm value, as Table IV demonstrates 23. Figure 5 also shows that on average, the shares of a firm 23 In the context of post-crisis Korea, Choi, Park and Yoo (2007) also show that the board independence, measured by the proportion of outside directors, has significant and positive effects on firm performance. 25

27 held by the CEO or board chairman increased over this period in general, thus the incentives of the CEO or board chairman are better aligned with the incentives of the shareholders. In Figure 5, the average board size tends to shrink during this period, and as Table VI shows, the smaller the board size, the less frequent and severe the legal violations are. Therefore, the decrease in the board size may also be consistent with an improvement in the corporate governance of these firms. The improvement in corporate governance of these firms may be due to the more stringent accounting rules promulgated by the CSRC, and also the fiercer product market competition as China liberalizes its markets, especially since it joined the World Trade Organization in The decomposition of the sources of the improvement in corporate governance is an intriguing research topic for future explorations. 26

28 REFERENCES Berkman, Henk, Rebel A. Cole and Lawrence J. Fu, 2009, Expropriation through loan guarantees to related parties: Evidence from China, Journal of Banking and Finance, 33, pp Boycko, Maxim, Andrei Shleifer, and Robert W. Vishny, 1996, A theory of privatization, Economic Journal, 106, Chen, Gongmeng, Michael Firth, Daniel Gao and Oliver Rui, 2006, Ownership structure, corporate governance, and fraud: evidence from China, Journal of Corporate Finance, 12, Chernykh, Lucy, 2008, Ultimate ownership and control in Russia, Journal of Financial Economics, 88, Cheung, Yan-Leung, P. Raghavendra Rau and Aris Stouraitis, 2006, Tunneling, propping, and expropriation: evidence from connected party transactions in Hong Kong, Journal of Financial Economics, 82, Chhaochharia, Vidhi and Yaniv Grinstein, 2009, CEO compensation and board structure, Journal of Finance, 64, Choi, Jongmoo J., Sae Woon Park and Sean Sehyun Yoo, 2007, The value of outside directors: evidence from corporate governance reform in Korea, Journal of Financial and Quantitative Analysis, 42, Claessens, Stijn, Simeon Djankov and Larry H. P. Lang, 2000, The separation of ownership and control in East Asian corporations, Journal of Financial Economics, 58, Claessens, Stijin, Simeon Djankov, Joseph Fan and Larry H. P. Lang, 2002, Disentangling the incentive and entrenchment effects of large shareholdings, Journal of Finance, 57, Coles, Jeffrey, Naveen D. Daniel, and Lalitha Naveen, 2008, Boards: Does one size fit all? Journal of Financial Economics, 87, Deng, Jianping, Jie Gan and Jia He, 2008, The dark side of concentrated ownership in privatization: Evidence from China, Hong Kong University of Science and Technology Working Paper. 27

29 Faccio, Mara, and Larry Lang, 2002, The ultimate ownership of Western European corporations, Journal of Financial Economics, 65, Faccio, Mara, Larry Lang, and Leslie Young, Dividends and expropriation, American Economic Review, 91, Fan, Joseph, and T. J. Wong, 2002, Corporate ownership structure and the informativeness of accounting earnings in East Asia, Journal of Accounting and Economics, 33, Fan, Joseph, T. J. Wong and Tianyu Zhang, 2007, Politically connected CEOs, corporate governance, and Post-IPO performance of China's newly partially privatized firms, Journal of Financial Economics, 84, Haw, In-Mu, Bingbing Hu, Lee-Seok Hwang and Woody Wu, 2004, Ultimate ownership, income management, and legal and extra-legal institutions, Journal of Accounting Research, 42, Huang, Yasheng, 2008, Capitalism with Chinese Characteristics, Cambridge University Press. Joh, Sung Wook, 2003, Corporate governance and firm profitability: evidence from Korea before the economic crisis, Journal of Financial Economics, 68, Johnson, Simon, Rafael La Porta, Florencio LopezdeSilanes and Andrei Shleifer, 2000, Tunneling, American Economic Review, 90, Kornai, Janos, 1979, Resource-constrained vs. demand-constrained systems, Econometrica, 47, Krueger, Anne O., 1990, Government failures in development, Journal of Economic Perspectives 4: La Porta, Rafael, Florencio Lopez-de-Silanes and Andrei Shleifer, 1999, Corporate ownership around the world, Journal of Finance, 54, Lemmon, Michael L. and Karl V. Lins, 2003, Ownership structure, corporate governance, and firm value: evidence from the East Asian financial crisis, Journal of Finance, 58, Li, Lingling, 2007, The cases of legal violations of Chinese listed companies (in Chinese), Renmin University Press. 28

30 Lin, Justin Yifu, Fang Cai and Zhou Li, 1998, Competition, policy burdens, and state-owned enterprise reform, American Economic Review 88, Lins, Karl, 2003, Equity ownership and firm value in emerging markets, Journal of Financial and Quantitative Analysis, 38, Masulis, Ronald, Cong Wang and Fei Xie, 2008, Agency problems at dual-class companies, Journal of Finance, forthcoming. National Bureau of Statistics of China, 2008, China Statistical Yearbook Rosenstein, Stuart and Wyatt, Jeffrey, 1990, Outside directors, board independence, and shareholder wealth, Journal of Financial Economics, 26, Rousseau, Peter L. and Sheng Xiao, 2007, Change of control and the success of China s share issue privatization, SSRN working paper. Rousseau, Peter L. and Sheng Xiao, 2008, Change of control and the success of China s share issue privatization, China Economic Review, 19, Shleifer, Andrei and Robert W. Vishny, 1994, Politicians and firms, Quarterly Journal of Economics, 109, Sun, Qian and Wilson Tong, 2003, China share issue privatization: the extent of its success, Journal of Financial Economics, 70, Wang, Songhua and Chen Yang, 2007, A study on the tunneling of large shareholders in Chinese listed companies (in Chinese), Southwest University of Finance and Economics Press. Xu, Hongcai, 2005, Classical Cases in Capital Management in China (in Chinese), Tsinghua University Press. Yermack, David L., 1996, Higher market valuation of companies with a small board of directors, Journal of Financial Economics 40,

31 Figure 1: An Example of the Cash Flow Rights and Control Rights for a publicly listed Chinese company with a private ultimate owner. Company name: Guangdong Midea Electric Appliances Co. Ltd. (Stock code: ) Data source: Guangdong Midea Electric Appliances Co. Ltd. Annual Report 2007 (Translated by the author) Mr. Xiangjian He 100% 90% 30% Foshan Shunde Lixun Investment Co. Ltd. Foshan Shunde Tiantuo Investment Co. Ltd 21% 75% 30% Midea Group Co. Ltd % Foshan Shunde Kailian Industrial Co. Ltd 4.17% Guangdong Midea Electric Appliances Co. Ltd To compute the control rights held by Mr. Xiangjian He, the ultimate owner of this listed company, I sum up the minimum proportions of ownership along the control chains to get 50.91% (46.74%+4.17%, no double counting). To compute the cash flow rights of Mr. Xiangjian He, I sum up the products of the proportions of ownership along the control chains to get 43.74% (100%*21%%*46.74%+90%*75%*46.74%+90%*30%*4.17%+30%*4.17%=43.74%). The wedge between the control rights and cash flow rights is therefore 7.17% (50.91%-43.74%), and the ratio of the control rights over the cash flow rights is therefore 1.16 (50.91%/43.74%). As a side note, this company is one of the largest electric appliance companies in China, whose top shareholders include foreign institutional investors such as Morgan Stanley, Credit Suisse (Hong Kong), Bill & Melinda Gates Foundation Trust, Yale University and UBS AG.

32 Figure 2. The number of publicly listed companies in China This figure shows that between 2002 and 2007, as the total number of publicly listed companies in China grew from 1224 to 1550, the number of publicly listed companies with private individual owners in China grew from 216 to 520, or equivalently, from 18% to 34% of all publicly listed companies in China.

33 Figure 3. How do companies with private ultimate owners go public? How do the ultimate owners control the listed companies? This figure shows that in 2002, among all publicly listed companies with private ultimate owners, 68% went public through IPOs while 32% went public through the mergers and acquisitions of existing publicly listed companies. In 2007, 53% went public through IPOs while 47% went public through the mergers and acquisitions of existing publicly listed companies. This figure also shows that in 2002, among all publicly listed companies with private ultimate owners, 98% had pyramid ownership structures, while in 2007, 87% had pyramid ownership structures. The downward trend in that proportion over the years between 2002 and 2007 seems obvious.

34 Figure 4. The ownership structure of listed companies with private ultimate owners in China This figure shows that between 2002 and 2007, the average cash flow rights ( Cash ) of the ultimate owners increased steadily from 21% to 24.83%, while their average control rights ( Control ) increased from 32.41% to 33.46%. Over that period, the wedge between control rights and cash flow rights decreased from 11.42% to 8.64% on average, and the ratio between the control rights and cash flow rights decreased from 2.17 to 1.85 on average.

35 Figure 5. The corporate governance of listed companies with private ultimate owners in China This figure shows that between 2002 and 2007, the average proportion of independent directors (IDR) rose from 26% to 37%. The average board size decreased from 9.19 to On average, around 13%-17% of board directors hold shares of the publicly listed companies (BNUM). Intererestingly, on average, a board chairman holds more shares of the company than the CEO for any given year in the sample, and the gap seems to be growing. For example, in 2007, the board chairman hold on average 4.3% of the shares ( BSHARE ), while the CEO only holds 1.8% of the shares on average ( CEOSHARE ).)

36 Figure 6. The Industrial Distribution of Publicly Listed Companies with Private Ultimate Owners in China A majority (53%) of the sample firms are in the manufacturing industry, 16% of the sample firms are classified as Comprehensive, and 11% of the sample firms are in the Information Technology (IT) industry.

37 Figure 7. The Structure of Mr. Zhongbao Qiu s Business Empire (2005) (Translated and adapted from page 107 of Li (2007)) This figure shows how Mr. Zhongbao Qiu controlled three publicly listed companies: Fujian Sannong Co. Ltd, Zhongyou Longchang Co. Ltd, and Zheda Haina Co. Ltd., as well as some un-listed companies. By 2006, Mr. Qiu had tunneled a staggering 1.48 billion yuan through direct fund transfers and 907 million yuan through loan guarantees from these three publicly listed companies. Specifically, he tunneled 496 million yuan through direct fund transfers, and 302 million yuan through loan guarantees from Fujian Sannong Co. Ltd., 657 million yuan through direct fund transfers and 270 million yuan through loan guarantees from Zhongyou Longchang Co. Ltd., and 310 million yuan through direct fund transfers and 335 million yuan through loan guarantees from Zheda Haina Co. Ltd. The illegally enriched Mr. Qiu frequently appeared in casinos in Macao, Las Vegas, Malaysia, etc. He was arrested on February 25, 2006 and was sentenced to 20 years in prison plus a fine of one million yuan in November 2008.