A personal perspective on protecting investors of publicly listed Chinese firms

Abstract

The objective of this paper is to provide a personal perspective on how to protect investors of publicly listed Chinese firms. The key points of my discussion can be summarized as follows. First, I describe China’s investor protection problems and then discuss the importance of investor protection in China. This discussion raises the possibility that strong investor protection may not be a necessary condition for a nation’s economic prosperity. Second, I propose a conceptual framework that I argue all stakeholders should use when judging the superiority of alternative investor protection mechanisms. Third, I analyze the challenges and opportunities for academic researchers interested in studying China’s investor protection. I highlight the difficulty of drawing causal inferences from observed data, the difficulty of quantifying all costs and benefits of regulatory reforms, and the difficulty of China’s unique institutional environment, which may call for investor protection mechanisms with Chinese characteristics. I also identify exciting new research opportunities that China presents to corporate governance researchers.

Keywords:

• investor protection
• accounting frauds
• China

1. Introduction

Investor protection has been one of the most discussed topics in China since China’s opening of the Shanghai and Shenzhen stock exchanges in the early 1990s. While Chinese regulators have spent considerable resources in bolstering the protection of China’s stock market investors, the effectiveness of such efforts appears to be low, as shown by the miserable performance of the Chinese stock market to date.

The objective of this paper is to offer my personal view on how regulators and investors can better protect the minority investors of publicly listed Chinese firms. I will start the next section with a discussion of the nature of the problem and then ask whether and why we should care about the problem. Section 3 proposes a conceptual framework I argue we should use to assess competing investor protection mechanisms. Section 4 identifies the key challenges that academic researchers, regulators and investors face in selecting the optimal investor protection mechanisms for China and then discusses potential future research opportunities. Section 5 concludes.

2. What is the problem and why should we care?

2.1. What is the problem?

Owing to weak investor protection (e.g., Allen, Qian, & Qian, 2005), corporate insiders (i.e., management and controlling shareholders) of publicly listed Chinese firms have strong incentives to tunnel the resources of the listed firms under their control (Jiang, Lee, & Yue, 2010).¹ To conceal their tunneling activities, corporate insiders frequently resort to misstating listed firms’ financial reports. The scale and severity of such accounting frauds have been vividly displayed in the recent saga of alleged accounting frauds by many Chinese concept stocks listed in North America, triggered by aggressive short sellers in the US (Chen, Cheng, Lin, Lin, & Xiao, 2012; He, Wong, & Young, 2013; Lee, Li, & Zhang, 2013). One of the most well-known cases is the alleged accounting fraud of Toronto-listed Sino-Forest Corporation, uncovered by an obscure short seller Muddy Waters Research.² The disclosure of alleged fraud at Sino-Forest brought overnight fame to Muddy Waters Research’s founder Carson Block. More significantly, the fraud allegation forced Sino-Forest to eventual bankruptcy and caused a prominent hedge fund investor, John Paulson, to lose US$720 million.³

Such egregious accounting frauds are not limited to Chinese concept stocks listed abroad. One of the most well-known accounting fraud cases that occurred to firms listed in mainland China is Yin Guang Xia, uncovered by an influential business magazine Caijing. More importantly, there is a widely held view in China that accounting frauds are widespread in China and many of them go undetected.

Chinese regulators have experimented with many different kinds of regulatory reforms with the aim of improving Chinese listed firms’ financial reporting quality, including the overhaul of accounting standards, the strengthening of audit firm supervision, and increased mandatory disclosure requirements issued by the China Securities Regulatory Commission (CSRC) and the two stock exchanges.⁴ Unfortunately, many of these regulatory efforts have not been very effective. For example, Chinese regulators have undertaken many reform initiatives over the past two decades with an aim to improve the quality of Chinese audit firms (e.g., audit firms’ disaffiliation from government agencies in 1998, and the several waves of forced audit firm mergers since 1999). Despite such forceful regulatory efforts, however, the audit quality of many domestic Chinese audit firms is still viewed as inferior by both international and domestic investors. The insiders of many listed firms continue to regard aggressive earnings manipulation and tunneling as business as usual.

2.2. Why should we care?

Should regulators and investors be concerned about alleged accounting frauds and corporate insiders’ tunneling in publicly listed Chinese firms? To many readers, the answer seems obvious, and an affirmative yes. Supporting this view, a series of academic papers pioneered by La Porta, Lopez-De-Dilanes, Shleifer, and Vishny (1997, 1998) shows that failure to provide adequate investor protection carries significant economic costs for firms individually and countries as a whole, including higher ownership concentration, which leads to less efficient risk sharing, reduced capital allocation efficiency, lower equity valuation, and slower financial market development (see La Porta, Lopez-De-Dilanes, Shleifer, & Vishny, 2000, and La Porta, Lopez-De-Dilanes, & Shleifer, 2008, for reviews of this literature).

With regard to accounting frauds per se, Karpoff, Lee, and Martin (2008) document – based on a sample of accounting frauds committed by US firms – that, on average, firms lose 38% of their market values when news of their misconduct is reported. And 66.6% of the market value loss is due to lost reputation, rather than the market’s downward adjustment of fraudulent firms’ financial situations or expectation of legal penalties. Based on a sample of Chinese accounting frauds, Hung, Wong, and Zhang (2011) find that over a one-year event window centered on the date when news of the accounting fraud is reported, on average the fraudulent firms suffer a –30.8% abnormal stock return for relationship scandals, defined as scandals that primarily damage a firm’s political networks and hence its ability to conduct relationship-based contracting, and a –8.8% abnormal stock return for market scandals, defined as scandals that damage a firm’s market credibility and thus its ability to conduct market-based contracting.

More importantly, accounting frauds are contagious and could adversely affect non-fraudulent firms as well. Specifically, undetected accounting frauds would artificially inflate fraudulent firms’ stock prices temporarily, causing investors to lose the opportunity to invest their money in non-fraudulent firms that deserve more financing. In addition, undetected accounting frauds can also cause distortion in non-fraudulent firms’ capital investment and other strategic decisions. A case in point is a widely discussed case study of C. Michael Armstrong’s failed bid in the late 1990s to turn around the ailing AT&T, an American icon. Mr. Armstrong’s failure to execute his strategies was costly to both AT&T, which was forced to be broken apart and sold, and Mr. Armstrong himself, who was held up as an example of a CEO that didn’t execute its strategy well in a swift marketplace. However, according to a 2004 Wall Street Journal article, Mr. Armstrong argued that the demise of AT&T was partly due to massive fraud at WorldCom Inc. and other big players in the long-distance telecommunication business. The theory was that ‘If competitors hadn’t been fraudulently pumping up their numbers, Wall Street would have looked more favorably on AT&T – and given his strategy more time to work’ (Blumenstein & Grant, 2004). Likewise, the research by He et al. (2013) suggests that many US-listed China concept stocks that were not accused of accounting frauds experienced something similar after the disclosure of several high-profile accounting fraud scandals among Chinese concept stocks listed in North America, including Sino-Forest.

All of these accounting scandals suggest the importance of investor protection in boosting investor confidence and ensuring financial market development and economic growth. However, an interesting question that has not been frequently asked is whether strong investor protection is a necessary condition for a nation’s economic prosperity. That is, is improving investor protection the only way to economic prosperity for countries with weak investor protection? This question is important for many emerging market economies because improving a country’s investor protection is a herculean task in countries with weak institutional environments. This question is especially relevant to China because China has experienced miraculous economic growth over the past three decades despite lack of strong investor protection.

The evidence from Franks, Mayer, and Rossi (2009) suggests that the answer may be no. Specifically, Franks et al. (2009) test one key proposition from the influential La Porta et al. (1997, 1998) literature, that concentrated ownership is a response to deficient investor protection. La Porta et al. (1998) argue that in countries with inadequate minority protection, investors would seek to protect their investments with the direct exercise of control through large share blocks. That is, concentrated ownership is a response to deficient investor protection. La Porta et al. (1998) cite the differences in ownership concentration and investor protection in the United Kingdom and the United States versus continental Europe to support their argument. However, after analyzing the long-run evolution of investor protection and corporate ownership in the United Kingdom over the twentieth century, Franks et al. (2009) find no evidence that investor protection had a significant impact on dispersion of ownership. They find that even in the absence of investor protection, rates of dispersion of ownership were high in the United Kingdom, associated primarily with mergers.⁵ Franks et al.’s evidence raises the possibility that investor protection may not be a necessary condition for economic prosperity.

Finally, even if investor protection is a necessary condition for a nation’s economic prosperity, one can still not immediately conclude that all nations with weak investor protection should strengthen their countries’ investor protection. The reason is that the observed investor protection level in any country is the outcome of multiple institutional forces (i.e., an equilibrium). Hence, a unilateral forced change of a country’s investor protection carries both costs and benefits, many of which are unintended (e.g., DeFond, Wong, & Li, 2000). In addition, the benefits from such forced changes could be small while the costs could be large in many emerging market economies, due to weak law enforcement (Ke & Zhang, 2014).

Overall, my personal view is that it is still an open question whether strong investor protection is a necessary condition for a nation’s economic prosperity. At the minimum, regulators and investors in developing countries such as China should proceed with extreme caution when proposing dramatic investor protection reforms. Doing nothing could be better than doing something.

3. How to protect investors: A conceptual framework

Hard-core corporate governance activists may not like the conclusion drawn at the end of the previous section. This is not surprising because whenever there is a change of leadership in either government regulatory bodies or business entities, the new leadership always needs to show some concrete actions in order to demonstrate their value and accountability to relevant stakeholders. Doing nothing may not be an option for most leaders. For this reason, I believe it is imperative to develop a common conceptual framework that stakeholders can use in the debate of competing investor protection proposals in both China and other countries.

In this section I share my own thoughts on this important issue. I believe there are two important questions we need to ask ourselves in any investor protection debate. First, have we considered all the costs and benefits of any proposed investor protection change, including both direct and indirect costs and benefits? While this advice seems obvious, many government policy makers around the world keep floundering about it. Government regulators seem too optimistic about the expected benefits from changes in investor protection laws but they very often underestimate the costs of such regulatory changes. Therefore, it is more often than not that changes in investor protection laws not only fail to eliminate the agency problems they intend to solve but also create new unintended negative consequences. A good example to illustrate this point is US policymakers’ repeated but failed attempts to regulate the level of executive compensation. For example, Perry and Zenner (2001) show that the US tax legislation in 1992, which capped the corporate income tax deduction of non-performance-related compensation at one million dollars (IRS tax code 162(m)) and the compensation disclosure rules enacted in 1993, caused dramatic increases rather than decreases in top executives’ real compensation levels. Similarly, Faulkender and Yang (2013) show that the 2006 US regulatory requirement of disclosing compensation peers failed to mitigate US firms’ opportunistic peer selection activities in executive compensation determination. Chinese securities regulators are not immune from such regulatory failures either, as shown by CSRC’s repeated failures in improving the quality of Chinese IPOs (Chen, Ke, Wu, & Yang, 2014).

Second, what is the appropriate perspective or unit of analysis we should use in evaluating the costs and benefits of any proposed change in investor protection? There are two different perspectives one could use in the debate of investor protection. The first perspective is to evaluate the costs and benefits of any proposed investor protection change, i.e., a marginal analysis, from an individual firm’s perspective. Assuming the firm’s objective is shareholder value maximization, the shareholders of the firm should support a proposed change in investor protection whenever the marginal benefits of the proposed change exceed the marginal costs. I denote such proposed investor protection changes as optimal solutions from a firm’s perspective. An important implication from this firm perspective is that strong investor protection (e.g., 100% board independence) is not necessarily optimal from a firm’s perspective. While a simple insight, I don’t think many leaders fully appreciate it.

The second perspective is to evaluate the costs and benefits of any proposed investor protection change from the perspective of a whole country. It is obvious that an optimal investor protection solution from one firm’s perspective may not be optimal from the whole country’s perspective, due to positive or negative externalities or both (recall the contagion of accounting frauds noted in the previous section). Because of this, I believe that we should adopt a country’s perspective to judge the optimality of any regulatory reform on investor protection.

Failure to use the correct unit of analysis would result in confusion and disagreement in debates of investor protection reforms, as illustrated by the recent saga of China’s e-commerce giant Alibaba’s failed bid for listing on the Hong Kong Stock Exchange (HKEx). According to a Wall Street Journal article (Steger, 2013), the key issue in the debate of Alibaba’s Hong Kong listing was whether HKEx should relax its long-held commitment to equal treatment for all shareholders to satisfy Alibaba’s request to allow its founder and senior management to maintain control over the composition of directors on its board. This issue became so contentious that many interested parties weighed in. In a blog, Mr. Joseph Tsai Chung, Alibaba Group Holding Ltd Vice Chairman, argued for the importance of preserving Alibaba’s innovative culture and challenged Hong Kong on whether it can ‘adapt to future trends and changes’. He wrote that ‘The question Hong Kong must address is whether it is ready to look forward as the rest of the world passes it by.’ In response to Mr. Tsai’s blog, especially his comment that ‘Partners are not just managers but they are owners of the business’, Mr. David Webb, a prominent Hong Kong corporate governance activist, retorted in his regular newsletter that, ‘Um no, Joe. The shareholders are the owners of the business. Get it right. You are either a partnership where the partners provide all the equity, or a company, where the shareholders do. You can’t be both.’⁶ Mr. Wang Shuo, an editor of an influential Chinese business magazine Caixin, argued that what matters in the Alibaba debate is whether the existing shareholders of Alibaba such as Softbank and Yahoo support management’s proposed governance change; if the existing shareholders have no objection, the views of the IPO share subscribers are irrelevant because they can price protect by discounting the IPO offer price in accordance with the proposed governance structure.⁷ HKEx CEO Charles Li himself also weighed in by posting a 2000 word account of one dream he had about the debate, summarizing the different positions of nine fictional characters: Mr. Tradition, Mr. Innovation, Mr. Disclosure, Mr. Big Investor, Mrs. Small Investor, Mrs. Practical, Mr. Righteous, Ms. Future, and Mr. Process.⁸

In my view, each of the parties involved in the Alibaba debate has a valid but incomplete point of view. What is missing in the debate is the fact that no one asked what is the correct perspective we should adopt to evaluate Alibaba’s proposed governance law change. Rather than taking a country’s perspective, many commentators took the perspective of either Alibaba’s management or Alibaba’s shareholders in the debate. This difference in perspectives could partially explain the conflicts among the different stakeholders in the debate.

4. Challenges and opportunities

In this section, I discuss the challenges and opportunities for academic researchers, regulators, and investors who are interested in improving China’s investor protection. While my focus is China, many of the issues apply to many other countries as well.

4.1. Challenges

The first challenge is the issue of causality. Most existing corporate governance research is based on associations rather than causal inferences (e.g., the cross-country comparison studies following La Porta et al. (1997, 1998)). In theory, statistical solutions such as the instrument variable regression can solve the endogeneity problem, but in reality they don’t, to the disappointment of many empirical economists (Coles, Lemmon, & Meschke, 2012). Therefore, we cannot draw strong causal inferences from most existing studies. This message is particularly important to zealous securities regulators in weak investor protection countries who wish to protect the minority investors of publicly listed firms. The evidence from prior association studies provides no guarantee that investors of weak investor protection countries can reap significant net benefits from regulatory reforms that aim to strengthen a country’s investor protection.

Second, while I believe that adopting a country’s perspective is the right way to go in evaluating the costs and benefits of any proposed regulatory change in investor protection, many costs and benefits of a regulatory reform are hard to quantify (e.g., SOX), even from one firm’s perspective, as noted by Chen, Ke, and Yang (2013). Therefore, researchers, regulators and investors usually have difficulty in quantifying the net benefit of a proposed regulatory reform ex ante.

Third and also most importantly, China is unique in many different aspects, including its history, culture, and political system. For example, China’s dominant role of the state, including the SOEs, is unique among the world’s large economies. Even in terms of the degree of ownership concentration, China also stands out in that the controlling shareholders of many large Chinese listed firms have a dominant ownership in the listed firm not seen in many other countries (Ke, Rui, & Yu, 2012). Therefore, I speculate that optimal solutions to China’s investor protection problems must also carry unique Chinese characteristics (Allen, Qian, Zhang, & Zhao, 2012). A simple mimicking of western-style investor protection mechanisms such as an independent board may not work in China (Chen, Guan, & Ke, 2013). However, the challenge we face today is that no one knows for sure what investor protection mechanisms work in China.

4.2. Opportunities

I believe this is a golden era for corporate governance researchers in China for several reasons. First, as noted in Sections 2 and 4.1, publicly listed Chinese firms are plagued with severe corporate governance problems, many of which are unique to China, and regulators and investors are crying out for answers to these problems.

Second, the Chinese Government has just started the process of restructuring China’s economy, including investor protection. In November 2013 China’s Communist Party (CCP) Central Committee released an ambitious economic reform blueprint, entitled ‘CCP Central Committee Resolution concerning Some Major Issues in Comprehensively Deepening Reform’.⁹ While the blueprint’s stated goals are lofty, the tasks required to achieve the goals are extremely challenging. In addition, the CCP’s blueprint provides only a sketch of China’s future economic reform plans, with plenty of crucial details left unspecified. At this point I don’t think anyone can predict for sure what China’s future will be like 10 to 20 years from now. Therefore, I believe there is a great opportunity for corporate governance researchers to provide a meaningful contribution to the ongoing discussion about China’s economic transformation, a transformation that will likely create massive ripple effects across the rest of the world.

While nothing is harder to predict than the future, I believe that the best predictor of future behavior is past behavior. In this sense, understanding the past behavior of publicly listed Chinese firms is critical. As a result of the past three decades of economic reforms, both failures and successes, China has already offered plenty of natural experiments and will offer even more in the future for empirical researchers to exploit in order to understand both the visible and invisible institutional forces that influence publicly listed Chinese firms’ behavior.¹⁰ Many natural experiments that researchers in many other countries don’t dare to dream of, have already occurred in China (e.g., see Chen, Ke and Yang, 2013, and Chan & Wu, 2010, for two examples). Furthermore, many natural experiments done by the Chinese Government happened without advance warning. While this could be viewed as bad from a policy-making perspective, such experiments are ideal from a research design perspective.

Chinese philosopher Lao Tzu once said, ‘A journey of a thousand miles must begin with a single step.’ So a pertinent question one could ask is where we should start in Chinese corporate governance research. To answer this question, I propose a 2×2 conceptual framework to classify all investor protection mechanisms into four types, as shown in Table 1.

Table 1. Classifications of investor protection mechanisms.

	Market-based approach (voluntary)	Government-based approach (mandatory)
Internal corporate Governance	Board size (cell 1)	Executive compensation regulation (cell 3)
External corporate governance	Shareholder activism (cell 2)	Rule of law (cell 4)

Any investor protection mechanism can be defined as either internal (e.g., board size or executive pay) or external (e.g., institutional investor activism or rule of law), or defined as market-based/voluntary (e.g., board size or institutional investor activism) or government-based/mandatory (e.g., executive compensation regulation or rule or law). Where does China stand in the table? I would say that most of the actions about investor protection in China occur in cells 3 and 4. That is, the Chinese Government has been heavily involved in protecting the minority investors of publicly listed Chinese firms by issuing a variety of laws, regulations, and implementation rules.

I propose we start China’s investor protection research agenda by answering the following two fundamental research questions:

1. Is it a good idea for China to stay in cells 3 and 4?

2. If the answer to question (1) is no, where should we go from cell 3 or cell 4?

By the way, these two questions were also one of the key contentious issues raised in the debate leading up to China’s 18th CPC Central Committee’s Third Plenum. While the communiqué of the Third Plenum appears to have reached a conclusion on (1) and (2), there is no doubt that the debate will continue. I believe academic researchers can make a significant contribution to this debate by providing scientific empirical evidence related to these two fundamental questions.

Before concluding this section, I would like to use one of my recent research papers to illustrate how we in academia can make a contribution to the ongoing investor protection debate in China. As noted in Section 2, the performance of China’s stock market has been miserable and the financial reporting quality of many publicly listed Chinese firms is still low. There is no shortage of opinions on what is wrong with China’s stock market and what should be done to improve the performance of the stock market. However, there is still a shortage of rigorous empirical research that can help shed light on the root causes of and potential effective solutions to China’s investor protection problems.

My recent co-authored working paper Chen et al. (2014) answers the call to the challenge by providing direct empirical evidence on the potential causes of and solutions to China’s struggling IPO market. Specifically, we examine how different types of IPO offer price regulations affect IPO firms’ financial reporting quality and the likelihood of IPO overpricing in China. While there is a large IPO literature, there has been little research that compares the costs and benefits of different IPO regulatory regimes. This is surprising considering the fact that there are significant variations in IPO regulation across both countries and time.

We consider two types of IPO price regulations, referred to as the market-based approach, where underwriters and investors, especially institutional investors, play the lead role in determining IPO offer prices, and the government-based approach, where a country’s securities regulator directly determines the IPO offer prices on behalf of all investors. A key advantage of our setting is that China’s IPO offer price determination changed from the government-based approach to the market-based approach and then reversed back to the government-based approach during our sample period, 1997–2004, thus creating a unique opportunity for us to examine the causal impact of different IPO offer price regulatory regimes on the welfare of public investors.

We find that IPO firms are more likely to show high quality financial reporting at the IPO time when IPO offer prices are determined by market forces rather than by securities regulators. However, contrary to regulators’ frequently expressed concern, we find no evidence that the IPOs are more likely to be overpriced when the offer prices are determined by market forces. Furthermore, we find that IPO firms’ financial reporting choices made at the time of the IPO have a long lasting impact on the firms’ subsequent financial reporting quality. Our results have important implications for the ongoing debate in China on how to regulate IPOs and how to incentivize the insiders of publicly-listed Chinese firms to make a commitment to high quality financial reporting.

5. Conclusion

This paper provides a personal view on how to protect the minority investors of publicly listed Chinese firms. Despite the constant efforts by regulators and shareholder activists, I argue that minority investors of publicly listed Chinese firms continue to face the risk of expropriation by corporate insiders. However, China’s dismal record of investor protection doesn’t imply that there is much government regulators can do to help reduce minority shareholders’ expropriation risk. I propose a conceptual framework that I argue we should use to analyze any issues arising from the debate over investor protection in China or any other country. Finally, I discuss the challenges and opportunities academic researchers face in contributing to the debate over investor protection in China. My personal view is that the future of China’s corporate governance research is bright and we academic researchers could make a significant impact on the development of China’s financial market. Therefore, I encourage more people to join me in studying the existing governance problems of publicly listed Chinese firms and identifying promising investor protection mechanisms with Chinese characteristics.

Acknowledgement

This paper is based on the author’s keynote speech made at the 2013 Mid-Year Discussion Forum of The China Journal of Accounting Studies held in Guangzhou University. I wish to thank the organizers of the 2013 Mid-Year Discussion Forum for giving me the opportunity to share my thoughts on investor protection in China and an anonymous reviewer for helpful comments. Any errors are mine.

Notes

1. It is important to note that publicly listed Chinese firms face multiple agency conflicts. Due to scope limitation, I only focus on the agency conflict between corporate insiders as a group and minority shareholders in this paper.

2. See http://www.muddywatersresearch.com/research.

3. Paulson became famous by making US$3.7 billion from short-selling US subprime mortgages in 2007.

4. See Chen, Ke, Wu, and Yang (2014) for a review of these regulatory reforms.

5. In this regard, it is useful to hear what Dr. Ian Malcolm said in the movie Jurassic Park (1993): ‘But again, how do you know they're all female? Does somebody go out into the park and pull up the dinosaurs' skirts?... If there is one thing the history of evolution has taught us it's that life will not be contained... No, I'm, I'm simply saying that life, uh... finds a way’ (italics added).

6. See http://webb-site.com/articles/aligaga2.asp.

7. See http://opinion.caixin.com/2013-09-26/100586509.html.

8. See http://www.hkex.com.hk/eng/newsconsul/blog/130925blog.htm.

9. An English version is available for download at http://chinacopyrightandmedia.wordpress.com/2013/11/15/ccp-central-committee-resolution-concerning-some-major-issues-in-comprehensively-deepening-reform/.

10. I often hear the argument that China changes too fast and therefore there is not much we can learn from China’s past for the prediction of Chinese firms’ future behavior. It is true that China changes almost on a daily basis. Yet, I would argue that many fundamental institutional forces remain intact and therefore we can still learn a lot about Chinese firms’ future behavior from studying their past behavior. The fact that Chinese investors are still complaining about weak investor protection despite three decades of economic reforms supports my argument.