zhiwen zhu_ multiple- agent relations

7/25/2019 Zhiwen Zhu_ Multiple- Agent Relations

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International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 31 (2009)

EuroJournals Publishing, Inc. 2009

http://www.eurojournals.com/finance.htm

Multiple Principal-Agent Relationships, Corporate-Control

Mechanisms and Expropriation Through Related Party

Transactions: Evidence from China

Zhiwen Zhu

China Center for Economic Research, Peking University, Beijing, 100871, P.R. China

Room 301A, Section 1, Wanliu campus of Peking Univ., 29#

Wanliu Middle road, Haidian District, Beijing, ChinaE-mail: [email protected]

Tel: +86-10-51604364; Fax: +86-10-62751474

Hao MaChina Center for Economic Research, Peking University

Beijing, 100871, P.R. ChinaE-mail: [email protected]

Tel: +86-10-62756573; Fax: +86-10-62751474

Abstract

This study investigated the intermediation of expropriation in the linkage between

corporate governance and firm value. We manifested the triple principal-agent relationships

among minority shareholders, majority shareholders and the board of directors, and

conceptualized the expropriation as rents demanded by majority shareholders tocompensate their agency function in a theoretical framework of internal and external

corporate-control mechanisms for firms with concentrated ownership structure. By using

related party transactions as a direct measure for expropriation, and the data of related partytransactions between 2002 and 2006 on Chinas stock market, we corroborated the negative

value effect of expropriation, and found that the controlling capability of controlling

shareholders, ownership balancing, identity of controlling shareholders, stock incentives forthe board/executives, and the proportion of tradable shares are significantly associated with

expropriation. Our work on expropriation would provide insight to understand the

relationship between corporate governance and firm value, and lay a basis for future theory

building on corporate governance.

Keywords: Corporate Control, Expropriation, Agency Theory, Related Party Transactions

JEL Classification Codes:G34

1. IntroductionWith the recent myriads of corporate scandals, both in the industrial and financial sectors, the interestsin corporate governance has gained further momentum. As such, understanding the various specific

challenges faced by corporate governance is of both practical importance and theoretical significance.

This paper, grounded in literatures in finance (Cheung, Rau, and Stouraitis, 2006; Claessens, Djankov,


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International Research Journal of Finance and Economics - Issue 31 (2009) 142

Fan, and Lang, 2002; La Porta, Lopez-De-Silanes, Shleifer, and Vishny, 2002; Lins, 2003) andeconomics (Clarke, 2003; Johnson, La Porta, Lopez-de-Silanes, and Shleifer, 2000; Pagano and Roell,

1998), as well as a host of related disciplines, e.g. strategy and management (Chang, 2003; Daily and

Dalton, 1994; Eisenhardt, 1989; Hill and Snell, 1988; Thomsen and Pedersen, 2000; Walsh andSeward, 1990), etc., tackles an important issue in corporate governance, namely the determinants of

expropriation, from a multiple principle-agent relationship (Arthurs, Hoskisson, Busenitz, and Johnson,

2008; Dharwadkar, George, and Brandes, 2000; Young, Peng, Ahlstrom, Bruton, and Jiang, 2003).

Early works in corporate governance concentrated mainly on the principal-agent conflicts dueto information asymmetry between boards of directors and executives and the ensuing opportunism of

executives on the Anglo-American capital markets (Eisenhardt, 1989; Finkelstein and Daveni, 1994;Mallette and Fowler, 1992). Corporate governance is thus to control the internal and external

entrenchment practices of executives through the internal and external control mechanism which either

align the interest of executives with the boards or monitor them directly(Boyd, 1994; Gibbs, 1993; Hill

et al., 1988; Walsh et al., 1990; Zajac and Westphal, 1994). On the other hand, works on the corporategovernance of continental European and Japanese firms, which are characterized by concentrated

ownership structure, found that there exists interest conflicts between majority shareholders and

minority shareholders, and majority shareholders could expropriate minority shareholders for theircontrolling advantage (Aguilera and Jackson, 2003; de Miguel, Pindado, and de la Torre, 2004;

Weinstein and Yafeh, 1994). Later studies found stronger evidence of expropriation in emergingeconomies (Chang, 2003), for which some authors dubbed tunneling (Johnson et al., 2000).

In this paper, we use the related party transactions (RPTs) as a direct measure for expropriation,

investigating the intermediation of expropriation in the linkage between corporate governance and firm

value in the institutional settings of China. This paper will answer two questions: 1) Do expropriation

reduce firm value? 2) What factors of corporate governance are associated with expropriation?

2. Theory and HypothesesWe first construct a conceptual model of multiple principal-agent relationships which underlies the

hypotheses from the perspectives of principal-agent theory in the institutional settings of China, and

the hypotheses are derived subsequently. Albeit some ethical attacks, agency theory is still among themost persuasive and accepted theories to understand the corporate governance issues (Bohren, 1998;

Hendry, 2002).

2.1. Theoretical Framework

In institutional settings of China, the highly concentrated ownership structure1 coupled with non-

tradable shares and multiple objectives of majority shareholders lead to severer expropriation, whichoffer a unique context for further theorizing the agency problem.

2.1.1. Triple Principal-Agent Relationships

In markets with disperse ownership structure, the conflicts of interest between disperse investors and

boards/executives are the principal conflicts. Because the costs to monitor boards/executives directly

are extremely high for disperse shareholders, they either align the interests of boards/executives withthem through incentive contracts or choose voting by foot through the market for corporate control.

In contrast, the costs to monitor board/executives for large shareholders are low thus they have enough

1 To reform and recapitalize its failing State-owned enterprises (SOEs), the Chinese government established two stock

exchanges the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE) in 1990 and 1991,respectively. In order that the SOEs could be listed in priority, the China Securities Regulatory Commission (CSRC), the

regulator of the securities markets, imposed a strict quota system on which companies could be listed. Consequently, by

2006 the majority of the listed firms were State-controlled (over 70% in our sample), and the ownership structure was

highly concentrated (ownership of largest shareholder was 41% on average in our sample).


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143 International Research Journal of Finance and Economics - Issue 31 (2009)

incentives to monitor board/executives directly and alleviate the opportunism problem thereby. So thepresence of a large shareholder would be beneficial to disperse minority shareholders in the respect of

monitoring boards/executives in that they could play as free riders they may entrust the large

shareholder to monitor boards/executives for them. However, there is no free lunch, large shareholdersself-interest and opportunism would lead to rent-seeking they would expropriate disperse investors

by their controlling and informational advantages.

So there exist triple principal-agent relationships in listed firms with concentrated ownership

structure (Figure1). The first is the principal-agent relationship between minority shareholders and theboard of directors, which is also the fundamental principal-agent conflicts in markets with disperse

ownership structure, mostly referring to the Anglo-American capital markets. The board of directorssituates in a better position than minority shareholders in this duplet, because minority shareholders

actually can not monitor the board directly for the extremely high costs. The second is the principal-

agent relationship between majority shareholders and the board of directors. Majority shareholders

situates in a better position in this duplet, because the costs for them to monitor, assess or dismiss theboard are relatively low. So there are dual principals for the board, if the two principals have

conflicting objectives or decisions (Dharwadkar et al., 2000; Su, Xu, and Phan, 2008; Young et al.,

2003), the board would be in a dilemma, and it would have to choose an eclectic action. The third isthe principal-agent relationship between minority shareholders and majority shareholders. Also,

majority shareholders situates in a better position in this duplet because of their controlling andinformational advantages. Thus minority shareholders situates in the weakest position in the tripod(Figure1).


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Figure 1: Triple Principal-agent Relationship and the Internal and External Control Mechanism

Minority

shareholders

Objective:

stock price

Majority

shareholders

Multiple objectives:

Cash flow; policy

burden (e.g.

employment)

Board of directors

Multiple

objectives:

income; effort;turnover

RentsPrincipal

PrincipalPrincipal

Agent

AgentAgent

Internal

control

mechanism

Incentive

contracts;

monitor;

assess; dismiss

External control

mechanism

Markets for corporatecontrol; markets formanagers/directors;

rules, regulations andlaws

Non-tradable

shares

Stock

incentives

Non-tradable

shares Non-tradable

shares

Ownership

structure;

information and

monitoring

Turnover

External control

mechanism



External control

mechanism



Albeit unintentionally, minority shareholders can actually benefit from the alleviation of

opportunistic behavior of boards/executives by majority shareholders monitoring at the expense ofrents seized by majority shareholders. So we can deem this relationship as: minority shareholders

entrust majority shareholders to monitor the board/executives, as a cost, they are subject to the

expropriation (rents) by majority shareholders. The antecedents and consequence of the expropriation(rents), which are measured directly by RPTs, are the thesis of this paper. Theoretically, whether

minority shareholders suffer loss from the expropriation (rents) depends on their benefits and expenses

from their agency contract with majority shareholders. On the other hand, rents are seized by majority

shareholders through the action of the board. Because there are two principals for the board, if the twoprincipals have conflicting objectives or decisions, the board would be in a dilemma, and it would have

to choose an eclectic action which makes majority shareholders seize reasonable rents. So theoretically,majority shareholders could not expropriate minority shareholders discretionarily, the motivation and

capability for them to expropriate and the maximum rents they could seize depends on the objectives

and constraints of all the three players. Nevertheless, because rents can be deemed as the costs minority

shareholders pay to majority shareholders for their monitoring the board, we can infer that the moreeffectively majority shareholders can monitor the board; the more rents they demand, and with the

higher motivation they are to expropriate.


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Proposition 1: Among the three players the majority shareholders, the minority

shareholders and the board, majority shareholders situate in the strongest position,minority shareholders situate in the weakest position, the board situate in the middle.

Proposition 2: Whether expropriation is value-destroying or value-creating depends on

the tradeoff between the benefit the minority shareholders could gain from and the rentsthey must pay for the agency contract between minority shareholders and majority

shareholders.

Proposition 3: The more effectively majority shareholders can monitor the board; themore rents they demand, and with the higher motivation they are to expropriate.

2.1.2. Non-Tradable Shares

A large portion outstanding share is non-tradable in China2. There are two types of non-tradable shares:

State shares and Legal-Person shares. State shares are held by government agencies3. Legal-Person

shares are held by non-individual legal persons4. Legal-Person and State shares are similar because

most legal persons are ultimately controlled by the State and both types of shares are not tradable.

However, Legal-Person shares can be held by both private and State-controlled entities and both

domestic and foreign entities, actually a large portion outstanding shares of private or foreigncontrolled listed companies are also Legal-Person shares and thus not tradable (see Green, 2003 for an

extensive review regarding the development of China's stock market). In essence, the principal-principal conflicts are between tradable share holders (social investors) and non-tradable share holders(the State, State-owned enterprises, or legal persons) in China.

Proposition 4: Expropriation of minority shareholders by majority shareholders isessentially expropriation of tradable share holders by non-tradable share holders in

China.The market for corporate control serves as a discipline of last resort (Fama, 1980). However,

the split share structure in China affects the market for corporate control in two important ways. First,

because the State shares and/or Legal-Person shares held by the majority shareholders are non-tradable,they will neither benefit nor suffer from the stock price change, besides, they also need not worry about

the competition for corporate control. This causes the majority shareholders no longer concerning

about stock prices and thus directly renders the market for corporate control dysfunctional. Second, theexistence of non-tradable shares attenuates the liquidity of a firms shares and the overall liquidity of

the market, thus impairing information efficiency, aggravating the information asymmetry of market,

and reducing the benefits of market monitoring (Holmstrom and Tirole, 1993).

Proposition 5: Under the split share structure, the market for corporate control is

failure.

2.1.3. Heterogeneity of Objectives

There are two sources of minority shareholders value: dividends and capital gains. However, the

minority shareholders is in the weakest position in the tripod (Figure 1), so they have no enough

strength to pressure corporate insiders to disgorge cash(La Porta, Lopez-de-Silanes, Shleifer, and

Vishny, 2000), as a result, dividends payout is pinchpenny in Chinas listed firms (Faccio, Lang, and

2 In order that the State ownership could not be transferred to the private sector, which was due to the intentionally

ideological aversion to capitalism, through future trading, and that the State could retain absolute majority ownership and

ultimate control towards listed firms, the Chinese government split shares into tradable and non-tradable. Tradable sharescan be freely traded on various stock exchanges and be further divided into tradable A shares, B shares and H shares.

Tradable A shares, which are most important and can be owned only by domestic individuals and organizations, are

traded on Chinas two stock exchanges. B shares and H shares are for foreign investors, B shares are traded on the SHSEand the SZSE, whereas H shares are traded on the Hong Kong stock exchange.

3 Include the Bureau of State Property Management, the regional asset management bureaus, or the Solely State-Owned

Enterprises.4 Include listed firms, unlisted private firms, non-bank financial institutions and some SOEs.


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Young, 2001). Therefore, the only value for minority shareholders is capital gains, and their onlyobjective is the rise of stock price.

Proposition 6: The only objective of minority shareholders is the rise of stock prices.

Because the State shares and/or Legal-Person shares held by the majority shareholders are non-tradable, they do not concern about the stock price thereby. However, majority shareholders have other

economic, social and political objectives. First, although majority shareholders could not obtain capital

gains, they could control the cash flow discretionarily, thus economically they wish to maximize the

cash flow of the listed firm. Second, majority shareholders, who are the government agencies or State-owned enterprises (SOEs), have many social and political objectives

5, and SOEs also undertake many

policy burdens (Lin, Cai, and Li, 1998). Even non-State controlled legal persons have closeconnections with the government agencies or SOEs, thus have certain political objectives. But we

conjecture that for majority shareholders who are non-State controlled legal persons, their economic

objectives dominate their political objectives, whereas for majority shareholders who are the

government agencies or SOEs, their political objectives dominate their economic objectives.

Proposition 7: For majority shareholders who are non-State controlled legal persons,their economic objectives dominate their political objectives, whereas for majority

shareholders who are the government agencies or the SOEs, their political objectives

dominate their economic objectives.

Directors also have multiple objectives in Chinas listed firms. As in the classical principal-agent model, agent (director) makes decisions through tradeoff between his income and effort, sodirectors have economic objectives. However, with an ownership structure dominated by State

institutions, it follows that the boards of most listed companies would be dominated by State

representatives, while board seats occupied by individual and corporate investors would be few. Most

of these State representatives are Communist Party officials; they could be promoted to a higherposition in the government or Party hierarchy in the future

6. So these directors concern more about

their political future rather than merely income. Although economic performance is now an indicator

the Party assessing its officials, political performance plays a more important role. Because these Staterepresentatives are appointed by majority shareholders - the government agencies or SOEs, majority

shareholders could use turnover as a means to directly control them.

Proposition 8: For directors of non-State controlled listed firms, their economicobjectives dominate their political objectives, whereas for directors of State controlled

listed firms, their political objectives dominate their economic objectives.

2.1.4. Internal and External Control Mechanism

The external control mechanism of corporate governance includes the market for corporate control, the

market for directors/managers and the derivative action of stockholders(Hill et al., 1988; Walsh et al.,1990). We have demonstrated that under the split share structure, the market for corporate control is

failure (Proposition 5). Besides, because most directors/executives are appointed directly or indirectly

by the government or the Party, whereas the political rather than economic performance is the major

indicator the government or the Party assessing its officials, the market for directors/managers does notwork well in China. Furthermore, some researches on the apparent bias against private ownership in

property rights disputes suggests that Chinas political institutional norm resolves the conflict between

public and private interests in favor of the former (Nee, 1992; Peng and Luo, 2000). This is partiallydue to lacking an independent judiciary and unclear laws governing private property rights, thus the

5 For example, a major objective of the Communist government since 1989 has been to maintain societal stability by

maintaining social equity, ensuring full employment and refraining from taking such profit enhancing measures as asset

divestiture and job cuts.6 In fact, the leaders of the 50 largest Solely State-Owned Enterprises some being the parents of multiple listed firms

are directly appointed by the Politburo.


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property rights are difficult to enforce (Su et al., 2008). In fact, there was no formal law protectingprivate property until 2007.

Proposition 9: The external control mechanism is dysfunctional in China

There are two broad classes of internal control options: incentive contracts and monitoring(Walsh et al., 1990). However, they are not equally effective on the governance of the triple principle-

agent relationships. For the minority shareholders board duplet, incentive contracts would be weakly

effective whereas monitoring is ineffective as the costs for minority shareholders to directly monitor

the board are unaffordable and directors even of the State controlled firms have certain economicobjectives. For the majority shareholders board duplet, monitoring would be in dominance as most

listed firms are State controlled (Proposition 8). For the minority shareholders majority shareholdersduplet, both incentive contracts and monitoring would be effective on the control of expropriation. The

ownership structure, which could be deemed as the incentive contract between the duplet, would affect

majority shareholders motivation to expropriate, whereas the information and monitoring system

inside the listed firms would affect their capability to expropriate.

2.2. Hypothesis

Given the theoretical framework, we can derive the hypotheses readily regarding related party

transactions (RPTs) in the institutional settings of China.

2.2.1. Related Party Transactions and Firm Value

RPTs being a direct measure for expropriation, whether they are value-destroying or value-creating

depend on the tradeoff between the benefits the minority shareholders could gain from and the rentsthey must pay for the agency contract between minority shareholders and majority shareholders

(Proposition 2). However, because Chinas majority shareholders have multiple objectives rather than

purely economic objectives, they are likely to demand more rents than their counterparts in other

countries, other things being equal. As such, the rents are more likely to exceed the benefits in China.

Hypothesis 1: Related party transactions (RPTs) reduce firm value.

2.2.2. Corporate governance and related party transactionsThe political objectives such as resolving the policy burden of the parent SOEs are the dominant

objectives for majority shareholders of State controlled listed firms, whereas the economic objectives

are the dominant objectives for the majority shareholders of non-State controlled listed firms(Proposition 7). Thus the former would have stronger motivation to expropriate in order to resolve their

policy burden aside from achieving their economic goals. On the other hand, directors of State

controlled listed firms have no options other than being officials, they are more prone to be effectively

controlled and monitored by their superior institutions. So other things being equal, majorityshareholders of State controlled listed firms would have more controlling capability than their

counterparts of non-State controlled listed firms. Whereas the more effectively majority shareholders

can monitor the board; the more rents they demand, and with the higher motivation they are toexpropriate (Proposition 3).

Hypothesis 2: The likelihood, as well as frequency and intensity of RPTs are higher for

State controlled listed companies than for non-State controlled listed companies.

Hypothesis 3: The likelihood, as well as frequency and intensity of RPTs are positively

associated with the controlling capability of the controlling shareholders of listedcompanies.As we analyzed, rents are seized by majority shareholders through the action of the board,

whereas there are two principals for the board, if the two principals have conflicting objectives or

decisions, the board would be in a dilemma, and it would have to choose an eclectic action which

makes majority shareholders seize reasonable rents. To some extent tock incentives wouldeconomically align interests of the board with minority shareholders, inducing them taking eclectic


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actions through which majority shareholders could seize less rents. Therefore, despitedirectors/executives ownership in China is very small (1% of total outstanding shares on average in our

sample), it would be beneficial to alleviate expropriation.

Hypothesis 4: The likelihood, as well as frequency and intensity of RPTs are negatively

associated with the directors/executives stock ownership.Many researchers argued that the presence of multiple block holders could be an effective

mechanism for reducing expropriation, as multiple block holders would monitor one another in order

to protect their own interests, to the benefit of minority shareholders (Lins, 2003; Pagano et al., 1998).Even in case of collusion between block holders, minority shareholders are likely to benefit as

coordination problems between block holders potentially increase the cost of tunneling. Also, thepresence of multiple block holders would attenuate the capability that individual block holders could

effectively control and monitor the board; as a result, they demand fewer rents (Proposition 3).


associated with the ownership balancing of multiple block holders.With the increase of the proportion of tradable shares, which is either due to fewer non-tradable

shares held by majority shareholders in IPO thus they have weaker controlling capability and demand

less rents, or due to the conversion of non-tradable shares into tradable shares7 thus the market for

corporate control works and the majority shareholders are likely to concern more about stock prices,

the expropriation is expected to be alleviated. In addition, we expect the block holdings of tradableshares by institutional investors, in spite of the 5% limitation, are beneficial for minority shareholdersto monitor and balance the power of majority shareholders.

Hypothesis 6: The likelihood, as well as frequency and intensity of RPTs are negativelyassociated with the proportion of tradable shares.


associated with the concentration degree of tradable shares.It was not until 2001 that the China Securities Regulatory Commission (CSRC) the regulator

of the securities markets - established the requirement that each listed firms should have twoindependent directors on its board. Independent directors are expected to represent the interests of

small shareholders and are considered an independent check on deviant managerial behaviors (Fama,

1980; Shleifer and Vishny, 1997), thus the presence of independent directors may be helpful toalleviate expropriation.

Hypothesis 8: The likelihood, as well as frequency and intensity of RPTs are negativelyassociated with the proportion of independent directors in the board of directors.

The information and monitoring system inside listed firms is helpful for minority

shareholders to monitor majority shareholders. Thus we expect the presence of audit committee

in listed firms could alleviate the expropriation. Besides, firms issuing foreign shares have to

submit to stricter regulations than those issuing only A shares, and firms issuing H shares also

have to submit to regulations from Hong Kong regulators, so we expect listed firms offering

foreign shares would have more perfect information and monitoring system and thus fewer

RPTs.Hypothesis 9: The likelihood, as well as frequency and intensity of RPTs are lower for

listed companies establishing the audit committee than for listed companies notestablishing the audit committee.

7 In IPO, Chinas regulators typically required that tradable A shares account for about one third of a firms total

outstanding shares. Until July 1999, the CSRC limited the maximum ownership of tradable A shares to 0.5%, when thislimitation was raised to 5.0%. This regulation effectively prohibited block holdings of tradable A shares. However, on

Aprial 29, 2005, the CSRC announced a program by which non-tradable shares would be converted into tradable shares.

By the end of 2006, the process was essentially complete, with more than 95 percent of the affected companies

completing the conversion.


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Hypothesis 10: The likelihood, as well as frequency and intensity of RPTs are lower for

listed companies offering both A shares and H shares than for listed companies notoffering H shares.

Hypothesis 11: The likelihood, as well as frequency and intensity of RPTs are lower for

listed companies offering both A shares and B shares than for listed companies notoffering B shares.

Majority shareholders holding non-tradable shares do not concern about stock prices for their

holdings are not tradable, which also render the market for corporate control dysfunctional. So we canexpect the effects of the controlling capability of majority shareholders on expropriation are different

for listed firms with different proportions of tradable shares. One extreme case would be that RPTs aremore positively associated with the controlling capability for listed firms with non-tradable shares than

for listed firms without non-tradable shares, as the market for corporate control for the latter firms

would restrain majority shareholders from expropriating to some extent.

Hypothesis 12: The proportion of tradable shares and the controlling capability of the

controlling shareholders have an interaction effect on RPTs.Hypothesis 12a: The frequency and intensity of RPTs are more positively associated

with the controlling capability of the controlling shareholders for the listed companies

with non-tradable shares than for the listed companies without non-tradable shares.

3. Research Methodology3.1. Data and Sample

We collected all data from Sinofin, a database compiled by the China Center for Economics Research

(CCER) at Peking University. The Sinofin dataset provides RPTs, financial and corporate governance

information on companies listed on Chinese stock exchanges in Shanghai and Shenzhen. Our sample

includes 69045 RPTs announced by all listed firms between 2002 and 2006. The total number of listedfirms in China was 1459 by 2006, following Cheung et al. (2006), we excluded firms in financial

industry for their special capital structure. Sinofin classifies RPTs into 29 types; we summarized the

frequencies and ratios of RPTs for each type in Table1, and the number and ratio of listed firms byRPTs frequencies in Table 2. According to Table 1, the frequencies of RPTs increase significantly with

time whereas the ratio of each type is rather stable across years, actually the frequencies doubled in

2006 relative to 2002. According to Table 2, the number and ratio of listed firms without announcingRPTs decrease with the time, whereas the number and ratio of listed firms announcing over ten RPTs

increase significantly with the time. After data merging, aggregating and excluding cases with missing

or unreasonable values (probably due to data input errors), the size of our company-year observations

ranged from 6203 to 6555 for the different regression models. We did not find systematic biases in ourestimates resulting from the treatment of missing values.

3.2. Measures

3.2.1. Dependent VariablesFor robustness, we designed three measures for RPTs the likelihood of RPTs, the frequency of RPTs

and the intensity of RPTs. The likelihood of RPTs is a dichotomy variable: 0 for observations withoutannouncing RPTs; 1 for observations announcing at least one RPT. The frequency of RPTs is the de

facto frequencies of RPTs the observations announced. The intensity of RPTs is the average relative

scale of each RPT the scale of RPTs for each observation was divided by the total assets to obtain therelative scale of RPTs, and then the relative scale was divided by the frequency of RPTs to obtain the

intensity of RPTs.

For the institutional settings of China, the minority shareholders only objective is the rise ofstock prices (Proposition 6). So the measure of firm value should also be market based. Thus, we


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measured firm value as the Cumulative Abnormal Return (CAR) of its stock price, adjusted for splitsand dividend payouts. The measure is calculated as follows:

==

==N

t

tjti

N

t

titi RRARCAR1

,,

1

,, )( , (1)

Where tiR , is the return on A shares of the listed firm i for day t, and tjR , is the value-weighted

average return of industry j to which the listed firm i belong for day t.

Table 1: Frequencies and Ratio of RPTs (2002 - 2006)

2002 2003 2004 2005 2006 TotalTrans.

typea Freq.Ratio

(%)Freq.

Ratio

(%)Freq.

Ratio

(%)Freq.

Ratio

(%)Freq.

Ratio

(%)Freq.

Ratio

(%)

1011 1938 20.27 2485 20.55 2797 22.85 2854 18.79 3564 17.85 13638 19.75

1012 2377 24.87 2894 23.94 3277 26.77 3507 23.08 3938 19.73 15993 23.16

1021 402 4.21 399 3.3 428 3.5 435 2.86 568 2.85 2232 3.23

1022 190 1.99 212 1.75 225 1.84 236 1.55 271 1.36 1134 1.64

1023 1 0.01 13 0.11 5 0.04 0 0 0 0 19 0.03

1031 418 4.37 518 4.28 573 4.68 668 4.4 1021 5.11 3198 4.63

1032 940 9.83 1360 11.25 1221 9.97 1639 10.79 2171 10.88 7331 10.62

1041 21 0.22 49 0.41 21 0.17 18 0.12 6 0.03 115 0.17

1042 24 0.25 32 0.26 31 0.25 35 0.23 15 0.08 137 0.2

1051 168 1.76 46 0.38 164 1.34 248 1.63 33 0.17 659 0.95

1052 106 1.11 35 0.29 124 1.01 157 1.03 16 0.08 438 0.63

1061 171 1.79 179 1.48 145 1.18 181 1.19 361 1.81 1037 1.5

1062 105 1.1 89 0.74 107 0.87 205 1.35 465 2.33 971 1.41

1071 694 7.26 674 5.57 604 4.93 1062 6.99 1782 8.93 4816 6.98

1072 711 7.44 989 8.18 918 7.5 1840 12.11 2950 14.78 7408 10.73

1081 1 0.01 10 0.08 1 0.01 4 0.03 0 0 16 0.02

1082 0 0 7 0.06 0 0 0 0 4 0.02 11 0.02

1091 6 0.06 0 0 5 0.04 3 0.02 7 0.04 21 0.03

1092 4 0.04 7 0.06 4 0.03 9 0.06 6 0.03 30 0.04

1101 10 0.1 9 0.07 11 0.09 17 0.11 16 0.08 63 0.091102 49 0.51 75 0.62 58 0.47 72 0.47 74 0.37 328 0.48

1111 1 0.01 107 0.89 16 0.13 43 0.28 209 1.05 376 0.54

1121 0 0 0 0 1 0.01 0 0 3 0.02 4 0.01

1122 3 0.03 2 0.02 0 0 1 0.01 3 0.02 9 0.01

1131 47 0.49 34 0.28 15 0.12 19 0.13 106 0.53 221 0.32

1141 76 0.8 34 0.28 36 0.29 28 0.18 63 0.32 237 0.34

1151 63 0.66 71 0.59 69 0.56 75 0.49 76 0.38 354 0.51

1991 450 4.71 755 6.24 549 4.48 753 4.96 870 4.36 3377 4.89

1992 583 6.1 1005 8.31 838 6.84 1083 7.13 1363 6.83 4872 7.06

Sum 9559 100 12090 100 12243 100 15192 100 19961 100 69045 100

a 1011 listed firm buys commodities from related party;1012 listed firm sells commodities to related party;1021 listed

firm buys assets other than commodities from related party;1022 listed firm sells assets other than commodities to

related party;1023 assets replacement;1031 listed firm provides labor services for related party;1032 listed firmreceives labor services from related party;1041 listed firm acts as an agent of related partys products and

services;1042 related party acts as an agent of listed firms products and services;1051 related party leases out assets

to listed firm ;1052 listed firm leases out assets to related party;1061 listed firm provides capital for relatedparty;1062 related party provides capital for listed firm;1071 listed firm provides guarantees or mortgages for related

party;1072 related party provides guarantees or mortgages for listed firm;1081 listed firm provides management

contracts for related party (listed firm gets income);1082 related party provides management contracts for listed firm(related party gets income);1091 listed firm transfers R&D projects to related party (listed firm gets income);1092

related party transfers R&D projects to listed firm (related party gets income);1101 listed firm provides licensing

agreements for related party;1102 related party provides licensing agreements for listed firm;1111 listed firm

provides remuneration for important directors/executives;1121 listed firm confers assets to related party;1122 related

party confers assets to listed firm;1131 debt restructuring between listed firm and related party;1141 non-monetary


11/23


transactions between listed firm and related party;1151 joint ventures between listed firm and related party;1991

other transactions from which listed firm gets income;1992 other transactions for which listed firm expends.

Table 2: Listed Firms' Number and Ratio by RPTs Frequencies (2002 - 2006)a

2002 2003 2004 2005 2006 TotalTrans.

Freq. numberRatio

(%)number

Ratio

(%)number

Ratio

(%)number

Ratio

(%)number

Ratio

(%)number

Ratio

(%)

0 157 13.17 110 8.76 71 5.28 104 7.75 42 2.96 484 7.381~10 717 60.15 727 57.88 858 63.84 744 55.44 739 52.01 3785 57.74>10 318 26.68 419 33.36 415 30.88 494 36.81 640 45.04 2286 34.87Sum 1192 100 1256 100 1344 100 1342 100 1421 100 6555 100

alisted firms in financial industry are excluded

Table 3: Descriptive Statistics and Correlationsa

Variables mean s.d. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

1. Likelihood of RPTs 0.93 0.262. Frequency of RPTs 10.60 12.43 0.24

3. Intensity of RPTs 0.31 12.84 0.01 -0.01

4. Non-State controlled listedfirm

0.29 0.45 -0.09 -0.15 -0.01

5. Proportion of tradable shares 0.42 0.13 -0.05 -0.01 -0.01 0.09

6. Ownership of the largestshareholder

0.41 0.17 0.16 0.25 0.02 -0.32 -0.51

7. Board/executives ownership 0.01 0.05 -0.02 -0.04 -0.00 0.18 -0.03 -0.118. Ownership of 5 largest

tradable share holders0.02 0.02 -0.09 -0.09 -0.01 0.18 0.11 -0.43 0.22

9. Herfindal index 0.21 0.14 0.14 0.24 0.01 -0.30 -0.57 0.97 -0.09 -0.4210. Proportion of independentdirectors

0.32 0.08 0.07 0.04 -0.02 0.12 0.06 -0.07 0.05 0.06 -0.08

11. Audit committee 0.41 0.49 0.03 0.06 -0.01 -0.04 0.01 0.00 0.03 0.05 0.00 0.1212. B share 0.07 0.25 -0.01 0.04 -0.01 -0.06 0.17 -0.05 -0.03 0.01 -0.07 0.01 -0.04

13. H share 0.02 0.15 0.01 0.05 -0.00 -0.08 0.04 0.07 -0.02 -0.04 0.13 -0.16 0.05 -0.0414. Abnormal transaction status 0.09 0.29 -0.09 -0.11 0.02 0.14 0.00 -0.13 -0.04 0.05 -0.12 0.03 -0.08 0.07 -0.0115. Logarithm of total assets 9.21 0.45 0.15 0.32 -0.01 -0.24 0.07 0.24 -0.06 -0.06 0.25 -0.02 0.06 0.10 0.27 -0.3416. Industry-adjusted previous

year market-to-book ratio0.61 5.13 -0.00 -0.04 -0.00 0.06 -0.07 -0.03 -0.01 0.04 -0.02 -0.02 -0.02 0.05 -0.01 0.15 -0.13

17. Industry-adjusted previous

year debt ratio0.04 0.74 -0.07 -0.03 0.01 0.07 0.00 -0.04 -0.03 0.04 -0.04 0 .01 -0.03 0.08 -0.01 0.28 -0.15 -0.02

aN=6186

3.2.2. Independent Variables

We measured the controlling shareholders identity by the dummy variable Non-State controlled listedfirm: 0 for observations that are State controlled; 1 for observations that are non-State controlled

(mostly private or foreign controlled). We follow La Porta et al. (2002) in assuming the ultimate owner

of the largest shareholders has effective control over a firm. Actually, the absence of cumulative voting

procedures in China reinforces the idea that the ultimate owner of the largest shareholder has effectivecontrol. So we measured the controlling capability of the controlling shareholders by the variable

Ownership of the largest shareholder. Stock incentives were measured by the variable

Board/executives ownership. We measured the ownership balancing of multiple block holders by thevariableHerfindal index, which was calculated as the squared sum of the percentage of shares held by

the 10 largest shareholders. The larger the value of this variable is, the more concentrated the stocks arein the hands of a few shareholders, and the less the ownership balancing is. Tradable shares weredivided by the total shares outstanding to calculate the variableProportion of tradable shares, and we

measured the concentration degree of tradable shares by the variable Ownership of 5 largest tradable

share holders. The larger the value of this variable is, the more concentrated the tradable shares are inthe hands of a few investors. The number of independent directors was divided by the board size to

calculate the variableProportion of independent directors. Three dummy variables - Audit committee,B share and H share were used to measure whether an observation establishing an audit committee,

issuing B shares and H shares or not, respectively.


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3.2.3. Control Variables

Following some relevant studies (Berkman, Cole, and Fu, 2009; Cheung et al., 2006), we set Abnormal

transaction status, Logarithm of total assets, Industry-adjusted previous year market-to-book ratio, and

Industry-adjusted previous year debt ratio as control variables. Abnormal transaction status is a dummyvariable indicating whether an observation is under normal transaction status or under abnormal

transaction status (0 for normal; 1 for abnormal). The transaction status is imposed by the CSRC,

alerting investors about the financial status of listed firms. Logarithm of total assets is used to measure

the size of listed firms. Industry-adjusted previous year market-to-book ratio and Industry-adjustedprevious year debt ratio are used to measure the growth prospect and leverage of listed firms,

respectively. Finally, 12 industry dummies (13 industries: A through M) according to Guidelines forClassification of Listed Companies issued by the CSRC and 4 year dummies (5 years: 2002 - 2006)

were also included as control variables. We summarized variables in Table 3.

3.3. Estimation

3.3.1. Event Study

To explicate the causality between RPTs and firm value, we investigated the value effect through thereactions of stock markets towards the announcement of RPTs. 9047 events of RPTs which were

announced during 2004 were analyzed. We first calculated the ex ante and ex post Cumulative

Abnormal Returns (CARs, see formula 1) in short-term, middle-term and long-term, then conducted

paired t tests between the CAR pairs to discover RPTs value effect in short-term, middle-term andlong-term respectively.

Concretely, we first set the announcement date be day 0, then calculated the CARs on days [-5,-

1] and days [1, 5] respectively for each event, after that we conducted paired t test between the CARpairs to get the short-term value effects. Similarly, we got the middle-term value effects between days

[-20,-1] and days [1, 20], and the long-term value effects between days [-250,-1] and days [1, 250].

3.3.2. Logit and OLS Regressions

ForLikelihood of RPTsis a dichotomy variable, we used logit regressions to estimate models with it,

whereas we used Ordinary Least Squares (OLS) regressions to estimate models with Frequency of

RPTsorIntensity of RPTsbeing dependent variables. Besides, for models with Intensity of RPTsbeingdependent variables, we excluded observations without announcing RPTs. The general form of

estimation models is:

itititit uZXy +

+

+= (2)

Where ity - Likelihood of RPTs, Frequency of RPTs, Intensity of RPTs,

itX - Independent variables vector

itZ - Control variables vector

itu - Disturbance

Clearly, itu of the same company in different years are highly correlated. Furthermore, there

may also be a company specific error component and the variances of itu may vary across companies.

To address these problems, we computed Huber-White robust standard errors allowing for group errors

by companies(Greene, 1993). We reported both logit and OLS estimation results with t-ratios based onHuber-White robust standard errors.


13/23


4. Results4.1. Value Effects of RPTs

We conducted event analysis on 9047 RPTs which were announced during 2004 to discover the value

effects of RPTs, the results of paired t test are presented in Table 4. In general, RPTs reduce firm valuesignificantly (p


14/23


Table 4: Value Effects of RPTsb

Industry-adjusted CAR (short-

term)

Industry-adjusted CAR (middle-

term)

Industry-adjusted CAR (long-

term)Trans.

typeaN

Days [-

5,-1]

Days

[1,5]tc

Days [-

20,-1]

Days

[1,20]tc

Days [-

250,-1]

Days

[1,250]tc

All 9047 0.0106 0.0079 4.40*** 0.0342 0.0194 12.84*** 0.3114 0.1683 40.05***

1011 1847 0.0108 0.0059 3.89*** 0.0346 0.0195 6.28*** 0.3184 0.1760 18.13***

1012 2203 0.0097 0.0057 3.26*** 0.0342 0.0203 6.21*** 0.3087 0.1614 20.58***

1021 302 0.0208 0.0099 2.89*** 0.0474 0.0077 5.50*** 0.3559 0.1889 7.82***

1022 142 0.0022 0.0106 -1.28 0.0228 0.0176 0.39 0.2893 0.1543 4.34***

1023 11 0.0168 0.0117 0.18 0.0224 0.0501 -0.47 0.3948 0.1454 2.25**

1031 399 0.0184 0.0109 2.88*** 0.0426 0.0258 3.19*** 0.3076 0.1661 9.61***

1032 1129 0.0140 0.0074 4.25*** 0.0362 0.0161 6.36*** 0.3041 0.1838 12.01***

1041 45 -0.0209 0.0127 -2.57** 0.0047 0.0845 -2.62** 0.3332 0.3819 -1.29

1042 23 0.0160 0.0016 1.00 0.0533 -0.0063 2.59** 0.3361 0.1386 2.47**

1051 38 0.0177 0.0276 -0.90 0.0603 0.0712 -0.65 0.3288 0.2423 1.77*

1052 26 -0.0011 0.0128 -1.40 0.0302 0.0264 0.29 0.3677 0.1479 3.98***

1061 125 0.0112 0.0176 -1.40 0.0305 0.0096 3.01*** 0.2748 0.0752 7.36***

1062 79 0.0106 0.0175 -1.05 0.0357 0.0122 2.01** 0.3267 0.1925 3.58***

1071 453 -0.0002 0.0145 -5.08*** 0.0222 0.0100 2.69*** 0.3258 0.1392 12.96***

1072 698 0.0023 0.0028 -0.19 0.0265 0.0150 2.28** 0.2762 0.1234 11.54***

1081 7 0.0319 0.0037 1.23 0.0926 0.0493 1.07 0.5716 0.1426 2.52**

1082 4 0.0177 0.0521 -5.23** 0.0159 0.0787 -1.75 0.5320 0.3617 1.69

1091 0 NA NA NA NA NA NA NA NA NA

1092 5 0.0599 -0.0046 1.63 0.1570 -0.0005 3.18** 0.6334 0.5022 0.60

1101 7 -0.0064 0.0062 -1.38 0.0482 0.0351 0.40 0.4091 0.0580 2.20*

1102 65 0.0169 0.0078 1.28 0.0427 0.0177 2.06** 0.3338 0.2193 2.53**

1111 76 0.0074 0.0065 0.14 0.0303 0.0136 1.61 0.2569 0.1605 3.15***

1121 0 NA NA NA NA NA NA NA NA NA

1122 2 0.0007 -0.0069 0.81 -0.0347 0.0537 -3.02 0.1892 -0.0574 1.71

1131 18 -0.0165 0.0052 -1.54 0.0120 -0.0130 1.04 0.3496 -0.0085 4.15***

1141 23 0.0150 0.0164 -0.11 0.0666 0.0181 1.78* 0.3566 0.2461 1.90*

1151 52 0.0091 0.0155 -0.85 0.0367 0.0228 0.94 0.3271 0.1781 4.67***

1991 501 0.0128 0.0095 1.12 0.0347 0.0209 2.63*** 0.3062 0.1873 7.28***

1992 767 0.0150 0.0115 1.72* 0.0351 0.0276 1.96* 0.3210 0.1832 10.32***

a1011 listed firm buys commodities from related party;1012 listed firm sells commodities to related party;1021 listed

firm buys assets other than commodities from related party;1022 listed firm sells assets other than commodities to

related party;1023 assets replacement;1031 listed firm provides labor services for related party;1032 listed firm

receives labor services from related party;1041 listed firm acts as an agent of related partys products andservices;1042 related party acts as an agent of listed firms products and services;1051 related party leases out assets

to listed firm ;1052 listed firm leases out assets to related party;1061 listed firm provides capital for related

party;1062 related party provides capital for listed firm;1071 listed firm provides guarantees or mortgages for relatedparty;1072 related party provides guarantees or mortgages for listed firm;1081 listed firm provides management

contracts for related party (listed firm gets income);1082 related party provides management contracts for listed firm

(related party gets income);1091 listed firm transfers R&D projects to related party (listed firm gets income);1092

related party transfers R&D projects to listed firm (related party gets income);1101 listed firm provides licensing

agreements for related party;1102 related party provides licensing agreements for listed firm;1111 listed firmprovides remuneration for important directors/executives;1121 listed firm confers assets to related party;1122 related

party confers assets to listed firm;1131 debt restructuring between listed firm and related party;1141 non-monetary

transactions between listed firm and related party;1151 joint ventures between listed firm and related party;1991

other transactions from which listed firm gets income;1992 other transactions for which listed firm expends.b The significance level of 1%, 5% and 10% are noted by ***, ** and *.

cPaired t test is used.


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4.2.3. Stock Incentives

Although Board/executives ownership is insignificant in predicting the likelihood of RPTs, it has

significantly negative effects on the frequency and intensity of RPTs (Table 6, p


16/23


Table 5: LOGIT Resultsabc

Likelihood of RPTs (0: no; 1: yes)

(1) (2) (3) (4) (5)

3.296*** 3.441*** 4.974***Ownership of the largest shareholder

(6.96) (7.03) (3.56)

4.118*** 4.267*** -2.338Herfindal index

(5.40) (5.42) (-1.12)-0.242** -0.240** -0.273** -0.271** -0.241**Non-State controlled listed firm

(-2.20) (-2.11) (-2.48) (-2.38) (-2.11)

-1.075** -1.036** -0.942** -0.906* -1.283**Proportion of tradable shares

(-2.42) (-2.26) (-1.94) (-1.80) (-2.43)

-0.915 -0.212 -1.072 -0.375 -0.133Board/executives ownership

(-1.25) (-0.20) (-1.47) (-0.36) (-0.13)

-5.487** -5.582** -5.907** -6.147** -6.117**Ownership of 5 largest tradable share holders

(-2.30) (-2.23) (-2.38) (-2.37) (-2.42)

-0.041 0.364 -0.030 0.356 0.371Proportion of independent directors

(-0.05) (0.44) (-0.04) (0.43) (0.45)

0.066 0.058 0.066 0.059 0.058Audit committee

(0.61) (0.53) (0.61) (0.54) (0.52)

-0.226 -0.165 -0.245 -0.184 -0.154B share(-1.17) (-0.82) (-1.28) (-0.92) (-0.76)

-0.966** -0.967** -1.206*** -1.205*** -0.814*H share

(-2.35) (-2.32) (-2.86) (-2.83) (-1.87)

-0.257* -0.220 -0.261* -0.222 -0.224Abnormal transaction status

(-1.66) (-1.35) (-1.69) (-1.36) (-1.37)

1.107*** 1.089*** 1.114*** 1.096*** 1.106***Logarithm of total assets

(7.04) (6.63) (7.10) (6.68) (6.63)

0.016** 0.015** 0.016**Industry-adjusted previous year market-to-book ratio

(2.26) (2.26) (2.26)

-0.064* -0.068* -0.060Industry-adjusted previous year debt ratio

(-1.66) (-1.68) (-1.57)

-8.808 -8.883 -8.464 -8.504 -9.061

Constant (-6.17) (-5.97) (-5.96) (-5.75) (-6.02)N 6504 6181 6504 6181 6181

Pseudo R2 0.14 0.14 0.13 0.14 0.14

aThe significance level of 1%, 5% and 10% are noted by ***, ** and *.

bAll regressions include the industry and year dummies.

cThe numbers in parentheses are z value based on Huber-White robust standard errors.


17/23


Table 6: OLS Resultsabde

Panel A: frequencies of RPTs Panel B: intensity of RPTs

(1) (2) (3) (4) (5) (6) c (1) c (2) c (3) c (4) c (5) c

0.213*** 0.215*** 0.183*** 0.148*** 0.070*** 0.065*** -0.017Ownership of the

largest shareholder (14.11) (13.82) (3.69) (2.82) (3.79) (3.42) (-0.29)

0.221*** 0.220*** 0.037 0.059 0.084*** 0.076*** 0.093Herfindal index

(12.83) (12.38) (0.67) (1.00) (4.31) (3.80) (1.52)

-0.046*** -0.047*** -0.051*** -0.052*** -0.047*** -0.045*** 0.067*** 0.064*** 0.067*** 0.063*** 0.063***Non-State controlled

listed firm (-4.13) (-4.10) (-4.57) (-4.58) (-4.12) (-3.73) (4.48) (4.20) (4.51) (4.21) (4.14)0.033** 0.035** 0.052*** 0.052*** 0.040** 0.048*** 0.012 0.004 0.024 0.015 0.016Proportion of tradable

shares (2.37) (2.42) (3.48) (3.37) (2.47) (2.81) (0.67) (0.22) (1.29) (0.76) (0.79)

-0.024*** -0.020*** -0.027*** -0.023*** -0.021*** -0.018** -0.048*** -0.035* -0.048*** -0.036* -0.036*Board/executives

ownership (-3.04) (-2.62) (-3.38) (-2.95) (-2.66) (-2.30) (-2.83) (-1.86) (-2.86) (-1.89) (-1.90)

0.002 0.001 0.001 -0.001 0.002 0.005 -0.031** -0.034** -0.028* -0.032** -0.032**Ownership of 5 largesttradable share holders (0.19) (0.09) (0.12) (-0.10) (0.15) (0.42) (-2.01) (-2.16) (-1.81) (-2.03) (-2.04)

-0.018 -0.020 -0.019 -0.021 -0.020 -0.020 0.025 0.025 0.025 0.025 0.025Proportion ofindependent directors (-1.28) (-1.40) (-1.34) (-1.47) (-1.41) (-1.33) (1.64) (1.62) (1.62) (1.61) (1.61)

0.014 0.014 0.014 0.014 0.014 0.016 -0.043*** -0.053*** -0.043*** -0.053*** -0.053***Audit committee

(1.22) (1.23) (1.20) (1.23) (1.23) (1.29) (-3.28) (-3.92) (-3.28) (-3.92) (-3.93)

0.009 0.006 0.008 0.005 0.005 0.009 -0.019 -0.023* -0.020 -0.023* -0.023*B share

(0.70) (0.42) (0.62) (0.34) (0.41) (0.69) (-1.49) (-1.74) (-1.52) (-1.76) (-1.76)

-0.043*** -0.047*** -0.058*** -0.061*** -0.049*** -0.045*** -0.018 -0.015 -0.024* -0.020 -0.021H share

(-2.71) (-2.87) (-3.69) (-3.80) (-2.96) (-2.61) (-1.31) (-1.05) (-1.71) (-1.40) (-1.41)

-0.008 -0.017* -0.009 -0.018* -0.017* -0.017 0.079*** 0.058*** 0.079*** 0.058*** 0.058***Abnormal transactionstatus (-0.83) (-1.67) (-0.97) (-1.74) (-1.67) (-1.55) (5.44) (3.79) (5.43) (3.80) (3.80)

0.276*** 0.279*** 0.273*** 0.277*** 0.278*** 0.276*** -0.208*** -0.209*** -0.211*** -0.212*** -0.212***Logarithm of total

assets (17.65) (17.24) (17.46) (17.08) (17.18) (16.34) (-12.62) (-12.56) (-12.74) (-12.66) (-12.67)0.020** 0.019** 0.020** 0.017* -0.001 -0.001 -0.001Industry-adjusted

previous year market-

to-book ratio(2.41) (2.35) (2.41) (1.89) (-0.07) (-0.08) (-0.09)

0.029*** 0.028*** 0.029*** 0.029*** 0.058** 0.057** 0.057**Industry-adjustedprevious year debt ratio (3.24) (3.27) (3.23) (2.66) (2.50) (2.49) (2.49)

-62.314 -64.790 -60.776 -63.284 -64.527 -64.977 0.599 0.627 0.635 0.657 0.664Constant

(-17.11) (-17.33) (-16.69) (-16.91) (-17.25) (-16.35) (2.25) (2.29) (2.39) (2.40) (2.43)

N 6489 6167 6489 6167 6167 5719 6014 5718 6014 5718 5718R2 0.32 0.32 0.32 0.32 0.32 0.31 0.15 0.15 0.15 0.15 0.15


bAll regressions include the industry and year dummies.cObservations without RPTs are not included in the estimations of equation 6 in panel A and all equations in panel B.

dThe numbers in parentheses are t ratios based on Huber-White robust standard errors.

eStandardized coefficients.

As to the effect of concentration of tradable shares, the likelihood and intensity of RPTs are allnegatively associated with the Ownership of 5 largest tradable share holders (Table 5 and Table 6,

p


18/23


because although B shares are also foreign shares, they are still under the regulation of the CSRC,

whereas H shares are subject to the regulation of Hong Kong. The stricter regulation and requirements

on corporate governance in Hong Kong capital markets would urge H share companies to ameliorate

their information and monitoring system. As a result, H share companies would have betterinformation and monitoring system than B share companies.

4.2.8. Control Variables

Among the control variables, theAbnormal transaction statusis positively associated with the intensityof RPTs (p


19/23


certain level (0.24 and 0.39 for the frequency and intensity of RPTs respectively in our estimation) thus

the controlling shareholders could exert an absolute control towards a firm, with the increase of

Proportion of tradable share, as there would be more resources for controlling shareholders to

expropriate, contrary they would expropriate more often and heavily.

Table 7: Interaction Effectabc

Panel A: frequencies of RPTs Panel B: intensity of RPTsProportion of

tradable shares =1

Proportion of tradable

shares1

Proportion of

tradable shares =1

Proportion of tradable

shares1

(1) (2) (3) d (1) (2) (3) d

0.215 0.213*** 6.387** -0.025 0.063*** -0.038Ownership of the largest shareholder

(1.14) (13.73) (2.14) (-0.13) (3.33) (-0.23)

-0.148 -0.046*** -1.061*** -0.627** 0.067*** 0.098***Non-State controlled listed firm

(-0.77) (-4.00) (-3.87) (-3.76) (4.40) (4.45)

0.022 -4.828* -0.008 -0.303*Proportion of tradable shares

(1.53) (-1.76) (-0.45) (-1.76)

20.535*** 0.780*Proportion of tradable shares* Ownership of

the largest shareholder (2.65) (1.87)

-0.056 -0.021*** -5.109*** -0.516** -0.037* -0.531**Board/executives ownership

(-0.42) (-2.74) (-2.87) (-3.55) (-1.94) (-1.97)

0.004 0.001 1.930 -0.084 -0.033** -1.017**Ownership of 5 largest tradable share holders

(0.04) (0.12) (0.30) (-0.68) (-2.07) (-1.98)

0.818*** -0.021 -2.864 0.346* 0.025 0.211Proportion of independent directors

(4.70) (-1.45) (-1.44) (2.31) (1.60) (1.60)

-0.166 0.013 0.302 0.525 -0.055*** -0.071***Audit committee

(-0.85) (1.15) (1.15) (1.94) (-4.05) (-4.03)

0.008 0.417 -0.020 -0.048B share

(0.62) (0.73) (-1.50) (-1.44)

-0.047*** -3.660*** -0.015 -0.074H share

(-2.84) (-3.12) (-1.03) (-1.24)

-0.018* -0.649* 0.056*** 0.133***Abnormal transaction status

(-1.76) (-1.70) (3.76) (3.77)

-0.027 0.279*** 6.960*** 0.612 -0.206*** -0.301***Logarithm of total assets

(-0.06) (17.25) (17.29) (0.93) (-12.40) (-12.19)

0.561* 0.020** 0.041** -0.474* -0.001 -0.000Industry-adjusted previous year market-to-book

ratio (2.08) (2.36) (2.31) (-2.37) (-0.04) (-0.05)

-1.091*** 0.026*** 0.402*** 1.014** 0.049*** 0.047***Industry-adjusted previous year debt ratio

(-3.67) (3.25) (3.37) (4.32) (2.71) (2.75)7.774 -64.599 -62.953 -13.913 0.605 0.668Constant

(0.15) (-17.22) (-16.77) (-1.24) (2.21) (2.39)

N 24 6143 6143 20 5698 5698

R2 0.95 0.31 0.33 0.98 0.15 0.15


bAll regressions include the industry and year dummies.

cThe numbers in parentheses are t ratios based on Huber-White robust standard errors.

dCoefficients of equation 1 and 2 both in Panel A and B are standardized; Coefficients of equation 3 both in Panel A and B

are not standardized in order for marginal analysis.

5. Discussion5.1. Implications

China is the largest and fastest growing emerging economy in the world. By 2007, it has ranked amongthe five largest economies in the world. So understanding the specific challenges faced by corporate

governance of its firms per se are of both practical importance and theoretical significance. Especially

for those multi-national corporations (MNCs) which are considering to entry the Chinese market andthus seeking partners for their strategic alliances (e.g. joint venture, licensing), our study on RPTs

provides them the immediate information and evidence about their potential partners corporate

governance, whereas other reliable information are extraordinarily difficult for MNCs to obtain as thecontrolling shareholders of these firms are prone to hide the true information for their private interest.

Our study also has practical implications for other emerging economies with concentrated ownership


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structure and weak investor protection. We suggested that in such economies the external control

mechanism were dysfunctional, thus the internal control mechanism were more important. Our study

indicated the expropriation is associated with ownership structure, incentive contracts, and the

information and monitoring system. By using these instruments appropriately, firms may mitigateagency problems in the context of weak investor protection.

Moreover, extant works in the field of corporate governance considered the expropriation to be

the result of principal-principal conflicts(Su et al., 2008; Young et al., 2003), thus implicitly

regarding expropriation as value destroying. However, our theoretical framework suggested minorityshareholders and majority shareholders is essentially principal-agent rather than purely principal-

principal relationship, and the expropriation in essence is the rent seized by majority shareholders tocompensate their agency function. Thus expropriation is indefinitely value-destroying if their benefits

from majority shareholders agency function exceed the expropriation, minority shareholders may

instead benefit. So a future research implication could be under what conditions minority shareholdersbenefits would exceed the expropriation.

Another implication concerns the ongoing debates between the agency theory and the

stewardship theory of corporate governance. Agency theory suggests that the interests of opportunistic,

self-interested agents conflict with those of principals, whereas stewardship theory suggests insteadthat executives' interests are aligned with company interests and that executives are thus more

intrinsically motivated than agency theory implies (Sundaramurthy and Lewis, 2003; Wasserman,2006). These two contrasting theories imply two contrasting approaches for corporate governance control or collaboration. In view of the fact that the theoretical framework of this study was established

in line with the agency theory, and it predicted results well, we are confident that the agency theory is

also robust to underlie corporate governance for other emerging economies with similar institutionalsettings. Thus monitoring and control instead of empowerment should be the major approaches for

corporate governance in these emerging economies.

Finally, although this study did not concern corporate strategy directly, it may have indirect

implications to the relationship between ownership structure and corporate strategy which had beendebated among several authors (Amihud and Lev, 1981; Amihud and Lev, 1999; Denis, Denis, and

Sarin, 1999; Lane, Cannella, and Lubatkin, 1999). A firm with high frequency of RPTs may, to some

extent, implication of many related parties, which is more likely to be diversified. So the result that thefrequency of RPTs is positively associated with the ownership concentration may imply the

diversification of a firm is positively associated with its ownership concentration. Amihud and Lev

(1981; 1999) claimed that companies with greater ownership concentration are less diversified, asmanagers, unless closely monitored by large block shareholders, will attempt to reduce their

employment risk through unrelated mergers and diversification. Following the same logic, in spite of

different conclusion, the positive association between diversification and ownership concentrationcould be explained as follows: the corporate strategy is de facto formulated by the controlling

shareholder as the board is tightly monitored and controlled by it in firms with concentrated ownership

structure; in addition, minority shareholders may diversify their portfolios, whereas the controlling

shareholder is locked in one firm, so the controlling shareholder, unless closely monitored by minority

shareholders, will attempt to reduce their risk through unrelated mergers and diversification; obviously,the more concentration of ownership is, the more stake the controlling shareholder is locked in one

firm, and the less minority shareholders can monitor the controlling shareholder, further, the morediversification the controlling shareholder would choose.

5.2. Limitations

An important limitation of the study is about the causality. While our hypotheses were stated in

associational terms, the logic behind implies that corporate governance "causes" RPTs. Unfortunately,even with panel data it is not possible to completely disentangle causal direction.

Another limitation of this study concerns the generalizability of its results. Specifically, to what

extent do our results generalize outside of China? Actually, even China is unique as to its split share


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structure (tradable/non-tradable shares) and Party control, as the largest emerging economy, it has

many commonalities in corporate governance with other developing countries or transitional

economies. So we believe our results would not be changed qualitatively when generalizing to these

economies with concentrated ownership structure.Finally, our research objective was to link corporate governance to firm value through the

intermediary expropriation which was measured by RPTs. For robustness, we designed three measures

for RPTs: the likelihood, the frequency and the intensity. However, by conducting event analysis, we

could only illustrate the value effect of the likelihood of RPTs, but could not explicate the causalitybetween the frequency or intensity of RPTs and firm value. In addition, although we have showed

RPTs are value-destroying in overall, we ignored several RPTs types which were identified as value-creating or value-neutral in the event study.

6. ConclusionThis study investigated the intermediation of expropriation in the relationship between corporate

governance and firm value. Based on extant works on principal-principal conflicts, we manifestedthe triple principal-agent relationships among minority shareholders, majority shareholders and the

board of directors. We also conceptualized the expropriation as rents demanded by majority

shareholders to compensate their agency function in a theoretical framework of corporate governancefor economies with concentrated ownership structure. In institutional settings of China, the highly

concentrated ownership structure coupled with non-tradable shares and multiple objectives of majority

shareholders would lead to more rents demanded and thus severer expropriation by majority

shareholders. So it offers a unique context for further theorizing and empirical testing of the agencyproblem. By using related party transactions as a direct measure for expropriation, we corroborated the

negative value effect of expropriation, and found that the controlling capability of controlling

shareholders, ownership balancing, identity of controlling shareholders, stock incentives for theboard/executives, and the proportion of tradable shares are significantly associated with related party

transactions. All these factors but the proportion of tradable shares had already been directly linked to

firm performance or value in literatures on corporate governance, corporate strategy, value creation,

accounting as well as finance and economics. We hope our work on related party transactions wouldprovide insight to understand the relationship between corporate governance and firm value or

performance, and lay a basis for future theory building on corporate governance.


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