Discussion of “Intra-Industry Effects of Corporate Scandal Announcements: Evidence from China”

1. Discussion of“Intra-Industry Effects of Corporate Scandal Announcements:Evidence from China” Donghui Wu School of Accounting & Finance The Hong Kong Polytechnic University July 2010

2. PetroChinaThe world’s most valuable company (FT500 ranking) • It is critical to understand Chinese market and Chinese firms. • The YZZ study: • The contagion effect of corporate frauds on firm value in China.

3. The contributions of YZZ • A methodology issue in the fraud literature: the identification problem • Only the detected frauds can be observed. • Some “non-fraud” firms could have committed frauds but have not been caught. • This study evaluates the probability of undetected frauds. • The contagion effect: negative market reaction to non-fraud peer firms. • This provides an estimate of the probability of a fraud occurrence, as perceived by investors.

4. The contributions of YZZ (Cont.) • YZZ also study the relationship between contagion effect and CG. • The evidence sheds new light on the value of CG. • Traditional approach: Performance(e.g., Tobin’s Q) = f(CG). • Correlated-but-omitted-variable problem • The short-window study (CAR[-2,+2]): easier to show the causality. • The setting of corporate frauds: a specific mechanism for CG to improve firm value.

5. Institution environment and frauds of Chinese listed firms • China’s transitional economy • Concentrated ownership structure • An ultimate controlling shareholder. • Tight government control of capital market • The listing process and subsequent capital raising are controlled by the CSRC. • Accounting-based regulations in the IPO, SEO and delisting decisions.

6. Institution environment and frauds of Chinese listed firms (Cont.) • Weak market mechanisms and investor protection • Lack of market for corporate control. • Limited monitoring role played by institutional investors and financial analysts. • Poor enforcement of law and regulations. • Poor information environment • High level of stock price synchronicity (Morck et al., 2000; Jin & Myers 2006). • Chinese firms are able to suppress bad news (Piotroski et al., 2010).

7. The nature of frauds • US firms (see Coffee, 2005): • Dispersed ownership structure – Type I agency problem. • Aggressive use of equity compensation. • Creating incentives for short-term financial manipulation. • Chinese firms • Concentrated ownership structure – Type II agency problem. • Controlling shareholders are more interested in diverting resources from listed firms under their control. • Moreover, they have incentives to manage earnings to meet the accounting benchmarks set by the regulators.

8. The contagion effect of frauds • On the one hand, the poor information environment suggests strong contagion effect. • Investors get new information to reassess the probability of frauds in the peer firms. • On the other hand, the poor institutional environment suggests week contagion effect. • Investors have anticipated that frauds are prevalent. • The announcements of frauds confirm their prior belief and thus do not convey much new information. • Therefore, how strong the contagion effect is should be an empirical issue.

9. The impacts of CG on the contagion effect • On the one hand, the weak country-level institutions suggest that firm-level CG plays an important role. • Fan & Wong (2006): the importance of auditing when country-level institutions are weak. • On the other hand, firm-level CG cannot be effective without the support of country-level institutions. • Doidge et al. (2006): countries matter so much for the effectiveness of CG. • Again, this is an empirical issue.

10. Interpretation of empirical findings • The main findings on the contagion effect (CAR[-2,+2]) • Fraud firms: -5.66% • Peer firms: -0.48% • Is the effect strong? • For fraud firms, the effect is not strong, compared with the US evidence. • For peer firms, the effect is relatively strong. • Comparable with the US evidence (Gleason et al. 2008). • The probability of similar but undetected frauds is:0.48%/5.66% = 8.5%. • Investors are indeed concerned with the possible problems in the peer firms!

11. Interpretation of empirical findings (Cont.) • Financial vs. non-financial frauds • Fraud returns: -5.34% vs. -6.09% • Contagion returns: -0.30% vs. -0.70% • Why weak reaction to financial frauds? • The Type II agency problem leads to more serious non-financial frauds. • Accounting information is less important in China in contracting or informing investors (Hung et al., 2008). • Or the accounting problems have been anticipated by the market. • e.g., ROA in (0, 1%] indicates earnings management to avoid delisting regulation.

12. Interpretation of empirical findings (Cont.) • The post-announcement drift (CAR[+3,+60]) • Fraud firms: -4.64% • Peer firms: -2.16% • Why the drift? • The market is not so efficient? • It is important to examine whether the drift is consistent with the hypotheses.

13. Interpretation of empirical findings (Cont.) • CG and contagion effect • Some CG variables are statistically significant in explaining the contagion effect. • However, economically, not so significant. • The significance can be evaluated by: • Dummy variables – β*1 • Continuous variables – β*1 std. dev.

14. Interpretation of empirical findings (Cont.) • Why these variables are not so significant in economic sense? • Theoretically, it could be due to the unimportance of CG in a weak institution environment. • Empirically, it could be due to research design.

15. Research design issues • Intra-industry contagion effect • In the first place, we assume homogeneity within industry, including CG. • However, this also suggests a lack of variability in the key variables of interest. • The clustering of fraud events in time. • The effect will be weaker for the same type of frauds that repeat. • This is exactly due to the contagion effect of early frauds.

16. Research design issues (Cont.) • Different types of frauds • Some frauds may not cause market reaction. • e.g., failure to disclose information on time. • This may not have any contagion effect since other firms have disclosed information on time. • Cases investigated by the CSRC could be more serious than the reprimand cases by exchanges. • Frauds in 2001 (“year of regulation”) could be associated with weaker reaction.

17. Some other suggestions • What are the determinants of frauds? • Chen et al. (2006 JCF) study the CSRC enforcement actions. • Board independence, CEO tenure, board meeting frequency, and CEO duality explain the likelihood of frauds. • But not ownership characteristics or regional development level. • It would be useful to analyze the probability of frauds and CG, and then test the contagion effects accordingly.

18. Some other suggestions (Cont.) • Intra-industry • The rationale: firms in the same industry share some common fundamentals. • Is this true? • Extending to other forms of contagion effect • Firms controlled by the same shareholders (e.g., Shanghai government). • One scandal (e.g., CHEN Liangyu) may reveal the problems of the shareholder.