Political Connections and Minority-Shareholder Protection: Evidence from Securities-Market Regulation in China

1. Political Connections and Minority-Shareholder Protection: Evidence from Securities-Market Regulation in China Henk Berkman University of Auckland, Auckland, New Zealand Rebel A. Cole DePaul University, Chicago, USA Lawrence Fu Standard Chartered Bank, Beijing, PRC Berkman-Cole-Fu AFA 2009

2. Summary • In this study, we examine the wealth effects of three regulatory changes designed to improve minority-shareholder protection in China. • We use the value of a firm’s related-party transactions as an inverse proxy for the quality of corporate governance at the firm. Berkman-Cole-Fu AFA 2009

3. Summary • We find that firms with weaker governance experienced significantly larger abnormal returns around announcements of the new regulations than did firms with stronger governance. • This evidence indicates that securities-market regulation can be effective in protecting minority shareholders from expropriation in a country with weak judicial enforcement. Berkman-Cole-Fu AFA 2009

4. Summary • We also find that firms with strong ties to the government did not benefit from the new regulations. • This evidence suggests that minority shareholders did not expect regulators to enforce the new rules on firms where block holders have strong political connections. Berkman-Cole-Fu AFA 2009

5. Background: Corporate Governance • Share ownership confers two set of rights • Cash-Flow Rights • Control Rights • How do owners of cash-flow rights ensure that they actually receive their pro-rata share of the firm’s cash flows? • “. . . How suppliers of finance to corporations ensure themselves of getting a return on their investment.” • Shleifer and Vishny (JF 1997) Berkman-Cole-Fu AFA 2009

6. The Changing Focus of Corporate Governance • Old focus: solutions to principal-agent problems arising from the separation of ownership from control. • How do we align interests of a firm’s managers with those of the firm’s shareholders? • Research focused on firms located in the U.S., where diffuse ownership (allegedly) is the norm. • Jensen and Murphy (1990): Median CEO ownership of U.S. firms was only 0.25%. • Holderness (2008): most U.S. firms have large block holders. Berkman-Cole-Fu AFA 2009

7. The Changing Focus of Corporate Governance • 1990s: Researchers became aware that, outside of the U.S. and Japan, dispersed ownership is the exception rather than the rule. • Instead, ownership is concentrated in the hands of a few families or the State. “Corporate Ownership Around the World,” La Porta, Lopez de Silanes, Shleifer and Vishny (JF 1999) Berkman-Cole-Fu AFA 2009

8. The Changing Focus of Corporate Governance • When ownership is characterized by controlling shareholders, the focus of corporate governance shifts: • New focus: Protection of the rights of minority shareholders. • How to prevent controlling shareholder, rather than the firm manager, from expropriating the wealth of minority shareholders. Berkman-Cole-Fu AFA 2009

9. The Changing Focus of Corporate Governance • In general, the evidence in the “law and finance” literature suggests that countries with stronger legal protection enjoy greater financial development. • Higher Stock Prices, more IPOs, larger stock markets, faster economic growth • Implication: Countries should try to improve the legal protection of minority shareholders Berkman-Cole-Fu AFA 2009

10. The Changing Focus of Corporate Governance • The “law and finance” literature distinguishes between legal protection and enforcement. • You can have strong legal protection, but this is of little value without enforcement. Berkman-Cole-Fu AFA 2009

11. The Changing Focus of Corporate Governance • The “law and finance” literature also distinguishes between judicial enforcement and regulatory enforcement. • Judicial enforcement is reactive. You have to sue in order to obtain relief. • Regulatory enforcement is pro-active. No one need sue in order to obtain relief. • This suggests that regulation can serve as a substitute for judicial enforcement, especially in emerging-market countries with weak judiciaries. • [Glaeser, Johnson and Shleifer (2001)] Berkman-Cole-Fu AFA 2009

12. Why Study China? • At least 1.4 billion reasons . . . . • Civil-law tradition with weak investor protection. • Courts have been reluctant to protect minority investors. • The State is usually the Controlling Shareholder but also is the Regulator. Berkman-Cole-Fu AFA 2009

13. Key New Regulations—2000 Q2 issued by the China Securities Regulatory Commission (“CSRC”) 1. New regulations for annual shareholder meetings that improved the rights of minority shareholders and imposed fiduciary duties on directors. 2. Prohibition against issuance of debt guarantees to controlling shareholders 3. Limitations on and improved transparency for asset transfers between related parties. Berkman-Cole-Fu AFA 2009

14. Hypotheses • Effective regulations will result in positive market-wide abnormal returns around the announcements. • Effective regulation will result in larger increases in value for minority shareholders of firms with poor governance (those that are more likely to be subject to expropriation by large block holders). • Increases in value will be inversely related to the firm’s closeness to the State. Berkman-Cole-Fu AFA 2009

15. Data Three sources: • Data on daily stock returns from Datastream • Accounting data, ownership data and data on related-party transactions from GTA/CSMAR. • Classification of largest shareholders from Delios et al. (2006) • State Bureaucrats • MOSOEs - Market Oriented SOEs • Private Entities Berkman-Cole-Fu AFA 2009

16. Data • Proxy for quality of governance: • EXPROP: the value of potentially harmful related-party transactions reported during 1999, scaled by market capitalization of the firm. Berkman-Cole-Fu AFA 2009

17. Data • Proxy for “political connectedness”: • degree of State ownership • Chinese listed companies: • Most are only “partially privatized” • The government maintains a controlling ownership position • Typically, about 1/3 of shares are publicly traded (“tradable shares”). • Remaining 2/3 of shares are “non-tradable.” • (This has changed during last couple of years). Berkman-Cole-Fu AFA 2009

18. Data • Tradable shares: no block holders by regulation (no one shareholder> 0.5%) • Block holders of Non-Tradable shares: • Government entity (strongest connection) • Government-controlled SOE (medium connection) • Private entity (weakest connection) • Non-tradable shares can be transferred, with consent of CSRC, but are highly illiquid. Berkman-Cole-Fu AFA 2009

19. Methodology We estimate cumulative mean-adjusted market returns around the announcement of each regulation using the following model: Market Return t = β0 + β1 Event 1 + β2 Event 2 + β3 Event 3 + ε t • Market Return t: return on day t for an equally weighted portfolio consisting of our 887 sample firms (excludes firms listed in Hong Kong) • Event windows: one day before CSRC issuance of regulation through one day after first publication of reg. • Estimation period: 250 days before each event. • β J , J = 1 to 3, cumulative mean-adjusted returns around each event Robustness test: estimate market-adjusted returns, controlling for the return on a portfolio of 24 Chinese firms that trade (only) on the Hong Kong exchange. Berkman-Cole-Fu AFA 2009

20. Market-Wide Price Reactions Berkman-Cole-Fu AFA 2009

21. Market-Wide Price Reactions Test has limited power: • Long Event Windows • High Market Volatility • Regulations might not have affected . . . - firms with the strongest governance - firms with the strongest ties to the government . . . resulting in insignificant coefficients. Berkman-Cole-Fu AFA 2009

22. More Powerful Test:Cross-Sectional Contrasts Firms with poor governance (high values of EXPROP) should benefit more than firms with good governance (low values of EXPROP), so we form a portfolio that is long on poor governance firms and short on good governance firms: (EXPROP High t – EXPROP Low t ) = β0 + β1* Event 1 + β2 * Event 2 + β3 * Event 3 + β4 * Markett + ε t Where: EXPROP High t = return day t on a portfolio of highest tercile EXPROP EXPROP Low t = return day t on a portfolio of lowest tercile EXPROP Berkman-Cole-Fu AFA 2009

23. Results:Cross-Sectional Differences in EXPROP(EXPROP High t – EXPROP Low t ) Berkman-Cole-Fu AFA 2009

24. Results:Cross-Sectional Differences in EXPROP(EXPROP High t – EXPROP Low t ) Private Firms > MOSOEs > State Bureaucrats Berkman-Cole-Fu AFA 2009

25. Cross-Sectional Differences:Indirect Measures of Corporate Governance • Largest shareholdings: Larger shareholding reduces the wedge between control rights and cash flow rights → less incentive to expropriate. • Non-controlling block holders: Larger non-controlling block holders → better monitoring of controlling shareholder → less expropriation. • MOSOE/Private is largest block holder: Increasingly more likely regulator will step in. • Foreign Shareholders (B-shares): More likely to be institutional and aware of expropriation • CEO is Chair • Independent Directors. • Firm Size and Leverage are included as control variables. Berkman-Cole-Fu AFA 2009

26. Cross-Sectional Differences:Multivariate Methodology We could estimate a simple OLS regression model: CARi, event J = β0 + β1,J* Largest Shareholdingi + β2,J* Non Controlling i + β3,J* Private i + ………. + ε iJ Problem: cross-correlation in the firm return processes from which the CARs are estimated. Solution: Sefcik and Thompson (1986) provide us with an alternative that gives unbiased estimates and standard errors that fully account for cross-sectional heteroscedasticity and cross-security dependence. Berkman-Cole-Fu AFA 2009

27. Multivariate Cross-Sectional Analysis • Orthogonalize all nine explanatory variables • For each orthogonalized variable, construct a portfolio that is short firms in the lowest third and long firms in the highest third of the orthogonalized variable’s distribution. • Regress the returns for each of the nine portfolios on the market return and a dummy variable (Events): R(OV-Hight) – R(OV-Lowt) = β0 + β1 Events + β2Market Returnt + ε t β1 corresponds to cross-sectional parameter estimate from a regression of CARs on the explanatory variable. Berkman-Cole-Fu AFA 2009

28. Berkman-Cole-Fu AFA 2009

29. Contributions to the Literature • First, we contribute to the literature on regulation as a substitute for judicial enforcement. • We provide new evidence that securities-market regulation can be effective in protecting minority shareholders from expropriation in a country with weak judicial enforcement. Berkman-Cole-Fu AFA 2009

30. Contributions to the Literature • Second, we contribute to the literature on “tunneling” that analyzes related-party transactions between listed firms and their controlling block holders. • We use the value of related-party transactions to calculate our proxy for the degree of expropriation by controlling block holders and provide evidence that regulations designed to protect minority shareholders disproportionately benefited firms with higher values of related-party transactions. Berkman-Cole-Fu AFA 2009

31. Contributions to the Literature • Third, we contribute to the literature on the importance of political connections. • We provide new evidence that, in a country with a weak judicial system, such as China, investors are skeptical that regulators will enforce rules that would limit expropriation by controlling block holders with strong political connections. Berkman-Cole-Fu AFA 2009

32. Contributions to the Literature • Fourth, we contribute to the growing body of work on corporate governance in China—especially the group of studies that have abandoned the “official” ownership scheme, which classifies owners of non-tradable shares primarily into two categories (“State” shares and “legal-person” shares) in favor of classifications based upon the identity of the ultimate owner (State shares, SOE shares and private shares). Berkman-Cole-Fu AFA 2009