Expropriation by corporate insiders and board effectiveness in an emerging economy

EXPROPRIATION BY DOMINANT SHAREHOLDERS AND BOARD EFFECTIVENESS IN AN EMERGING ECONOMY WU ZHONGHUA A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY OF BUSINESS DEPARTMENT OF STRATEGY & POLICY NATIONAL UNIVERSITY OF SINGAPORE 2009 ACKNOWLEDGEMENTS I would like to thank my advisor, Professor Andrew Delios, for his help at every step of my dissertation progress. The innovative ideas, thought, and depth of perceptions of Professor Delios have added incredible value to this dissertation and I am sincerely grateful. Furthermore, his continuous guidance and encouragement made the timely completion of this dissertation possible. I would like to extend my appreciation to Professor Edward Zajac and Prof Ishtiaq P Mahmood who were instrumental in shaping the direction of this dissertation. My discussions with them led to several breakthroughs in this project. The innovative ideas, resourcefulness, and sincere enthusiasm of my committee members: Professor Nitin Pangarkar and Dr. Krishna Udayasankar, were also invaluable. I also want to thank all the other faculty members and doctoral students at National University of Singapore who have in many ways shaped my academic perspective and have guided me through this journey. Finally, I would like to thank my husband and my newborn son. Without your love and unwavering support, this journey would not have been possible. I know that this was not my journey alone, and that you were there by my side – quietly, gently, continually pushing me onwards. And for that I will be forever grateful. ii TABLE OF CONTENTS ACKNOWLEDGEMENTS ii TABLE OF CONTENTS . iii SUMMARY. vi LIST OF TABLES . ix LIST OF FIGURES x LIST OF SYMBOLS . xi CHAPTER – INTRODUCTION . 1.1 Overview . 1.2 Research Questions . 1.3 Contribution 1.4 Organization of Dissertation . CHAPTER – INSTITUTIONAL ENVIRONMENT . 11 2.1 The Development of China Stock Market 12 2.2 Regulatory Response 15 2.3 Ownership Structure . 17 2.3.1 Tradable shares versus non-tradable shares . 19 2.3.2 A-shares, B-shares, and H-shares 24 2.4 Agency Conflict between Dominant Shareholders and Minority Shareholders 26 2.4.1 Related-party transactions 26 2.4.2 Prevalence of fund misappropriation transactions initiated by dominant shareholders 28 2.4.3 Regulations governing fund misappropriation transactions . 31 2.4.4 The case of Guangzhou Nanhuaxi Industrial Corporation . 33 2.5 The Board of Directors . 37 2.5.1 Board responsibilities . 39 iii 2.5.2 Board composition . 40 2.5.3 Independent directors . 42 2.6 Supervisory Board 47 2.7 Conclusion 50 CHAPTER – DOMINANT SHAREHOLDERS‟ EXPROPRIATION ACTIVITIES: INCIDENCE AND THEIR COSTS TO LISTED COMPANIES 54 3.1 Introduction . 54 3.2 Theory and Hypotheses 59 3.2.1 Ownership structure . 60 3.2.2 The board of directors 65 3.3 Data and Methodology 67 3.3.1 Regulations on non-operating fund transfer in Chinese listed companies . 67 3.3.2 Data 69 3.3.3 Dependent variables . 70 3.3.4 Independent variables 71 3.3.5 Control variables 72 3.3.6 Statistical model . 74 3.4 Results . 75 3.5 Additional Analysis 79 3.5.1 Impact of foreign retail investors . 79 3.5.2 Impact of dominant shareholder‟s portfolio considerations 80 3.5.3 Interaction between large shareholders 81 3.6 Discussion and conclusion 84 CHAPTER - THE ARENAS AND SOURCES OF INDEPENDENT D IR EC TOR S ‟ C HA LLE N G IN G IN V O LVE ME NT IN CORPORATE DECISION-MAKING 88 4.1 Introduction . 88 iv 4.2 Arenas of Independent Directors‟ Challenging Involvement . 91 4.2.1 Monitoring executive performance 92 4.2.2 Protecting corporate resources . 93 4.2.3 Providing counsel to executives . 94 4.3 Hypothesis Development 96 4.3.1 Business expertise 96 4.3.2 Support expertise . 98 4.3.3 Organizational power . 101 4.3.4 Social influence from corporate insiders . 103 4.3.5 The market for influential directors . 107 4.4 Data and Methodology 110 4.4.1 Sample 110 4.4.2 Dependent variables . 111 4.4.3 Independent measures 113 4.4.4 Control variables 115 4.5 Results . 118 4.5.1 Main results 118 4.5.2 Results on the market for influential directors . 124 4.5.3 Independent directors‟ impact on preventing dominant shareholders from engaging in fund misappropriation transactions: a complimentary analysis 127 4.6 Discussion . 130 4.6.1 Contributions 132 4.6.2 Limitations and future research . 134 4.6.3 Implications 137 4.6.4 Conclusion . 140 BIBLIOGRAPHY . 157 v SUMMARY This dissertation investigates dominant shareholders‟ expropriation activities and board effectiveness in an emerging economy. Chapter provides an overview of the dissertation and states its major contribution to the corporate governance literature and to the theoretical developments in strategic management and organization theory. Chapter begins by discussing the institutional environment concerning China‟s state-dominated capital market, corporate ownership structure and fund misappropriation transactions between listed companies and their dominant shareholder. It also discusses the institutions of the board of directors and the supervisory board as a potential solution to China‟s corporate governance problems. As the external merger and takeover market for corporate control seldom exists and there is weak legal protection for investors in emerging markets, checks to corporate insiders‟ expropriation activities are mainly provided by internal governance mechanisms. Based on the tenets of agency theory and social embeddedness perspective, Chapter addresses how corporate ownership structure and directors‟ affiliation with the dominant shareholder affect the incidence of that dominant shareholder‟s expropriation activities and the cost of such activities to a listed company. Specifically, this chapter examines whether the interests of state shareholders, foreign blockholders and corporate directors are consistent with the incidence and consequences of expropriation activities initiated by dominant shareholders. vi Regressions using data on all Shanghai-listed companies in 2004 and 2005 lend support to the predictions that the incidence of a dominant shareholder‟s expropriation activities decreases with the presence of foreign blockholders and increases with the percentage of affiliated directors, while the cost of such expropriation activities positively relates to the level of state ownership. Additional analysis is performed regarding the impact of foreign retail investors, dominant shareholders‟ portfolio considerations and other non-dominant large shareholders. As the board of directors is the highest internal control mechanism responsible for monitoring the activities of dominant shareholders, it is important to investigate the effectiveness of directors, especially independent directors. In addition to their limited power, independent directors are confronted with persistent challenges in making meaningful contribution to corporate decision-making. Drawing insights from multiple theoretical perspectives, Chapter explores how the challenging involvement of an independent director in corporate decision-making depends on the availability of the director‟s intellectual capital; social influence received from corporate insiders and his/her organizational power. It identifies three arenas that an independent director is expected to provide challenging opinions: “monitoring executive performance”, “protecting corporate resources”, and “providing counsel to executives”. Empirical analysis of Chapter utilizes a sample of 2,806 independent directors from all Shanghai-listed companies in 2005. Using non-acceptance opinions of these independent directors released in corporate annual reports, this chapter finds that intellectual capital structure and social context of vii independent directors, not simply their presence or functional background, deliver an important impact on corporate decision-making. By examining the impact of independent directors‟ provision of challenging opinions on their turnover in the focal company, this chapter suggests that micro-social factors involved in the relationship between corporate insiders and independent directors, by reducing the objectivity of independent directors‟ opinions, may ultimately compromise corporate control. viii LIST OF TABLES Table An Overview of China Stock Market 1998 - 2008 . 14 Table Ownership Structure of Chinese Listed Companies 2003 – 2008 19 Table Prevalence of Fund Misappropriation Transactions by Dominant Shareholders in Shanghai-listed Companies 2001-2005 . 30 Table A List of Companies that were Delisted Due to Fund Misappropriation Transactions (Jun 2001 to September 2005) 36 Table 5. Board Composition of Chinese Listed Companies 1999 - 2008 . 41 Table 6. Composition of the Supervisory Boards in Chinese Listed Companies 1999 - 2008 48 Table 7. Descriptive Statistics and Correlation Coefficients . 74 Table 8. Heckman Selection Regression of Incidence of Fund Misappropriation and Accrued Interest on Funds Misappropriated 78 Table 9. Additional Analysis Using Heckman Selection Regression on Incidence of Fund Misappropriation and Accrued Interest on Funds Misappropriated . 83 Table 10. Independent Directors' Opinions and Factor Analysis Result . 112 Table 11. Descriptive Statistics and Correlation Coefficients . 117 Table 12. OLS Regression on Determinants of an Independent Director's Challenging Opinions in the Arena of "Monitoring Executive Performance" 119 Table 13. OLS Regression on Determinants of an Independent Director's Challenging Opinions in the Arena of "Protecting Corporate Resources" 120 Table 14. OLS Regression on Determinants of an Independent Director's Challenging Opinions in the Arena of "Providing Counsel to Executives" 122 Table 15 Negative Binomial Regression Predicting How Soon an Independent Director Would Leave the Current Board 126 Table 16 Robustness Check on Independent Directors' Challenging Involvement in the Arena of "Protecting Corporate Resources" By Examining their Impact on Prevent Fund Misappropriation Transactions 129 Table 18. Industry Distribution of Firms in the Sample 141 ix LIST OF FIGURES Figure Prevalence of State-owned Shares in Chinese Listed Companies 2000 – 2008 . 20 Figure The Chinese-Style State Pyramid 21 Figure Distribution of Foreign Shares in Chinese Listed Companies 1999 2008 25 Figure Related-party Transactions in Companies Listed on Shanghai Stock Exchange 28 Figure Distribution of Related Parties of Shanghai-listed Companies involved in Related-party Transactions (2005) 28 Figure Amount of Funds Misappropriated by Dominant Shareholders in Shanghai-listed Companies 2003 - 2005 . 30 Figure Ownership Pyramid of Guangzhou Nanhuaxi Industrial Corporation 34 Figure Fund Misappropriation Transactions between Nanhuaxi Industrial Corporation and Its Dominant Shareholder or Affiliates of the Dominant Shareholder 34 Figure Average Number of Shareholders' Meeting in Chinese Listed Companies 2001 - 2008 . 38 Figure 10. 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The third part investigates how an independent director‟s intellectual capital, social influence, and organizational power affect that director‟s challenging involvement in on the corporate decision-making process. Her papers have been published at Management International Review, Business Times, included as Book Chapters, and presented at various conferences including the Academy of Management Annual Meetings and Academy of International Business Annual Meetings. 157 [...]... corporate governance centers on the principles of transparency, accountability, and fairness And the main mechanisms of corporate governance to look for include an independent board of directors, treatment of minority shareholders, and coordinating the interests of shareholders and corporate executives Currently, the main agency problem in the U.S and U.K is between the management and outside diverse... issue opinions, guidance opinions, and other non-legally binding guidance for listed companies For example, in 2001, the CSRC issued the Guidance Opinions on the 15 Establishment of an Independent Director System in Listed Corporations In 2002, the CSRC and the State Economic and Trade Commission promulgated the Code of Corporate Governance, which expands the Company Law by making more detailed and explicit... listed companies? And what are the arenas and sources of independent directors‟ challenging involvement in corporate decision-making? The empirical context for this dissertation covers all companies listed on the Shanghai Stock Exchange in 2004 and 2005 Choosing a large sample of listed companies in a single emerging economy rather than using crosscountry data is relevant to my research questions In contrast... effectively constrain corporate insiders from instigating and perpetrating frauds, discipline CEOs in firms with poor performance, and influence the processes of strategic choice, 6 change and control However, in addition to their limited power, independent directors are confronted with persistent challenges in making meaningful contribution to corporate decision making As a response, I examine to what extent... shareholders where managers pursue private benefits at the cost of the shareholders‟ interests In continental Europe and Japan, ownership is highly concentrated in the hands of main banks and financial institutions In East Asian economies where ownership is highly concentrated in the hands of controlling families, dominant shareholders are able to pursue self-interests via unchecked related-party transactions... challenging opinions: “monitoring executive performance”, “protecting corporate resources”, and “providing counsel to executives” And I identify the matches between the expected involvement of an independent director and the required sources to provide such involvement, and explore how an independent director‟s challenging involvement in different arenas affects the individual‟s turnover in the focal company... of board process, and emphasizes the roles of individual characteristics and social context in determining the performance of independent directors Furthermore, this dissertation integrates our understanding of the various arenas in which independent directors can exert valuable influence, and identifies the need for a match between the expected challenging involvement of independent directors, and. .. al, 2000; La Porta et al, 1999), and an inefficient allocation of investments (Wurgler, 2000) This dissertation takes the lead to explore how internal governance mechanisms including ownership structure and the board of directors influence the level of agency conflicts between the dominant shareholder and minority shareholders, in a setting situated in an emerging economy Much of the academic literature... empirical analysis, I utilize a sample of 2,806 independent directorships from all Shanghai-listed companies in 2005 The findings suggest that the intellectual capital structure and social context of independent directors deliver a significant impact on these directors‟ challenging involvement in the three arenas of corporate decision-making By examining the determinants and consequences of social influence... that hurt minority shareholders, false and inadequate financial disclosures, and stock market manipulation It is also responsible for advising on changes to laws, formulating regulations for the securities market, vetting listing applications, and providing supervision over companies, securities firms, investment institutions, sponsors, stock exchanges, professional bodies and individuals In addition, . This dissertation investigates dominant shareholders‟ expropriation activities and board effectiveness in an emerging economy. Chapter 1 provides an overview of the dissertation and states its. The corporate governance and financial economics literature have started to explore the effectiveness of institutional mechanisms in preventing dominant shareholders from engaging in expropriation. Shanghai Stock Exchange in 2004 and 2005. Choosing a large sample of listed companies in a single emerging economy rather than using cross- country data is relevant to my research questions. In