Expropriation by corporate insiders and board effectiveness in an emerging economy

EXPROPRIATION BY DOMINANT SHAREHOLDERS AND
BOARD EFFECTIVENESS IN AN EMERGING ECONOMY








WU ZHONGHUA








A THESIS SUBMITTED

FOR THE DEGREE OF DOCTOR OF PHILOSOPHY
OF BUSINESS
DEPARTMENT OF STRATEGY & POLICY

NATIONAL UNIVERSITY OF SINGAPORE




2009



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ACKNOWLEDGEMENTS

I would like to thank my advisor, Professor Andrew Delios, for his
help at every step of my dissertation progress. The innovative ideas, thought,
and depth of perceptions of Professor Delios have added incredible value to
this dissertation and I am sincerely grateful. Furthermore, his continuous
guidance and encouragement made the timely completion of this dissertation
possible.
I would like to extend my appreciation to Professor Edward Zajac and
Prof Ishtiaq P Mahmood who were instrumental in shaping the direction of
this dissertation. My discussions with them led to several breakthroughs in this
project. The innovative ideas, resourcefulness, and sincere enthusiasm of my
committee members: Professor Nitin Pangarkar and Dr. Krishna Udayasankar,
were also invaluable.
I also want to thank all the other faculty members and doctoral students
at National University of Singapore who have in many ways shaped my
academic perspective and have guided me through this journey.
Finally, I would like to thank my husband and my newborn son.

Without your love and unwavering support, this journey would not have been
possible. I know that this was not my journey alone, and that you were there
by my side – quietly, gently, continually pushing me onwards. And for that I
will be forever grateful.

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TABLE OF CONTENTS

ACKNOWLEDGEMENTS ii
TABLE OF CONTENTS iii
SUMMARY. vi
LIST OF TABLES ix
LIST OF FIGURES x
LIST OF SYMBOLS xi
CHAPTER 1 – INTRODUCTION 1
1.1 Overview 1
1.2 Research Questions 5
1.3 Contribution 8
1.4 Organization of Dissertation 9
CHAPTER 2 – INSTITUTIONAL ENVIRONMENT 11
2.1 The Development of China Stock Market 12
2.2 Regulatory Response 15
2.3 Ownership Structure 17
2.3.1 Tradable shares versus non-tradable shares 19
2.3.2 A-shares, B-shares, and H-shares 24
2.4 Agency Conflict between Dominant Shareholders and Minority
Shareholders 26
2.4.1 Related-party transactions 26

2.4.2 Prevalence of fund misappropriation transactions initiated by
dominant shareholders 28
2.4.3 Regulations governing fund misappropriation transactions 31
2.4.4 The case of Guangzhou Nanhuaxi Industrial Corporation 33
2.5 The Board of Directors 37
2.5.1 Board responsibilities 39

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2.5.2 Board composition 40
2.5.3 Independent directors 42
2.6 Supervisory Board 47
2.7 Conclusion 50
CHAPTER 3 – DOMINANT SHAREHOLDERS‟ EXPROPRIATION
ACTIVITIES: INCIDENCE AND THEIR COSTS TO LISTED
COMPANIES 54
3.1 Introduction 54
3.2 Theory and Hypotheses 59
3.2.1 Ownership structure 60
3.2.2 The board of directors 65
3.3 Data and Methodology 67
3.3.1 Regulations on non-operating fund transfer in Chinese listed
companies 67
3.3.2 Data 69
3.3.3 Dependent variables 70
3.3.4 Independent variables 71
3.3.5 Control variables 72
3.3.6 Statistical model 74
3.4 Results 75
3.5 Additional Analysis 79

3.5.1 Impact of foreign retail investors 79
3.5.2 Impact of dominant shareholder‟s portfolio considerations 80
3.5.3 Interaction between large shareholders 81
3.6 Discussion and conclusion 84
CHAPTER 4 - THE ARENAS AND SOURCES OF INDEPENDENT
DIREC T OR S ‟ CHA LLE NGING IN VOLV EME NT IN
CORPORATE DECISION-MAKING 88
4.1 Introduction 88

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4.2 Arenas of Independent Directors‟ Challenging Involvement 91
4.2.1 Monitoring executive performance 92
4.2.2 Protecting corporate resources 93
4.2.3 Providing counsel to executives 94
4.3 Hypothesis Development 96
4.3.1 Business expertise 96
4.3.2 Support expertise 98
4.3.3 Organizational power 101
4.3.4 Social influence from corporate insiders 103
4.3.5 The market for influential directors 107
4.4 Data and Methodology 110
4.4.1 Sample 110
4.4.2 Dependent variables 111
4.4.3 Independent measures 113
4.4.4 Control variables 115
4.5 Results 118
4.5.1 Main results 118
4.5.2 Results on the market for influential directors 124
4.5.3 Independent directors‟ impact on preventing dominant shareholders

from engaging in fund misappropriation transactions: a complimentary
analysis 127
4.6 Discussion 130
4.6.1 Contributions 132
4.6.2 Limitations and future research 134
4.6.3 Implications 137
4.6.4 Conclusion 140
BIBLIOGRAPHY 157

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SUMMARY
This dissertation investigates dominant shareholders‟ expropriation
activities and board effectiveness in an emerging economy. Chapter 1 provides
an overview of the dissertation and states its major contribution to the
corporate governance literature and to the theoretical developments in
strategic management and organization theory.
Chapter 2 begins by discussing the institutional environment
concerning China‟s state-dominated capital market, corporate ownership
structure and fund misappropriation transactions between listed companies and
their dominant shareholder. It also discusses the institutions of the board of
directors and the supervisory board as a potential solution to China‟s corporate
governance problems.
As the external merger and takeover market for corporate control
seldom exists and there is weak legal protection for investors in emerging
markets, checks to corporate insiders‟ expropriation activities are mainly
provided by internal governance mechanisms. Based on the tenets of agency
theory and social embeddedness perspective, Chapter 3 addresses how
corporate ownership structure and directors‟ affiliation with the dominant

shareholder affect the incidence of that dominant shareholder‟s expropriation
activities and the cost of such activities to a listed company. Specifically, this
chapter examines whether the interests of state shareholders, foreign
blockholders and corporate directors are consistent with the incidence and
consequences of expropriation activities initiated by dominant shareholders.

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Regressions using data on all Shanghai-listed companies in 2004 and
2005 lend support to the predictions that the incidence of a dominant
shareholder‟s expropriation activities decreases with the presence of foreign
blockholders and increases with the percentage of affiliated directors, while
the cost of such expropriation activities positively relates to the level of state
ownership. Additional analysis is performed regarding the impact of foreign
retail investors, dominant shareholders‟ portfolio considerations and other
non-dominant large shareholders.
As the board of directors is the highest internal control mechanism
responsible for monitoring the activities of dominant shareholders, it is
important to investigate the effectiveness of directors, especially independent
directors. In addition to their limited power, independent directors are
confronted with persistent challenges in making meaningful contribution to
corporate decision-making. Drawing insights from multiple theoretical
perspectives, Chapter 4 explores how the challenging involvement of an
independent director in corporate decision-making depends on the availability
of the director‟s intellectual capital; social influence received from corporate
insiders and his/her organizational power. It identifies three arenas that an
independent director is expected to provide challenging opinions: “monitoring
executive performance”, “protecting corporate resources”, and “providing
counsel to executives”.
Empirical analysis of Chapter 4 utilizes a sample of 2,806 independent

directors from all Shanghai-listed companies in 2005. Using non-acceptance
opinions of these independent directors released in corporate annual reports,
this chapter finds that intellectual capital structure and social context of

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independent directors, not simply their presence or functional background,
deliver an important impact on corporate decision-making. By examining the
impact of independent directors‟ provision of challenging opinions on their
turnover in the focal company, this chapter suggests that micro-social factors
involved in the relationship between corporate insiders and independent
directors, by reducing the objectivity of independent directors‟ opinions, may
ultimately compromise corporate control.

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LIST OF TABLES
Table 1 An Overview of China Stock Market 1998 - 2008 14
Table 2 Ownership Structure of Chinese Listed Companies 2003 – 2008 19
Table 3 Prevalence of Fund Misappropriation Transactions by Dominant
Shareholders in Shanghai-listed Companies 2001-2005 30
Table 4 A List of Companies that were Delisted Due to Fund Misappropriation
Transactions (Jun 2001 to September 2005) 36
Table 5. Board Composition of Chinese Listed Companies 1999 - 2008 41
Table 6. Composition of the Supervisory Boards in Chinese Listed Companies
1999 - 2008 48
Table 7. Descriptive Statistics and Correlation Coefficients 74
Table 8. Heckman Selection Regression of Incidence of Fund
Misappropriation and Accrued Interest on Funds Misappropriated 78
Table 9. Additional Analysis Using Heckman Selection Regression on

Incidence of Fund Misappropriation and Accrued Interest on Funds
Misappropriated 83
Table 10. Independent Directors' Opinions and Factor Analysis Result 112
Table 11. Descriptive Statistics and Correlation Coefficients 117
Table 12. OLS Regression on Determinants of an Independent Director's
Challenging Opinions in the Arena of "Monitoring Executive Performance"
119
Table 13. OLS Regression on Determinants of an Independent Director's
Challenging Opinions in the Arena of "Protecting Corporate Resources" 120
Table 14. OLS Regression on Determinants of an Independent Director's
Challenging Opinions in the Arena of "Providing Counsel to Executives" 122
Table 15 Negative Binomial Regression Predicting How Soon an Independent
Director Would Leave the Current Board 126
Table 16 Robustness Check on Independent Directors' Challenging
Involvement in the Arena of "Protecting Corporate Resources" By Examining
their Impact on Prevent Fund Misappropriation Transactions 129
Table 18. Industry Distribution of Firms in the Sample 141


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LIST OF FIGURES

Figure 1 Prevalence of State-owned Shares in Chinese Listed Companies 2000
– 2008 20
Figure 2 The Chinese-Style State Pyramid 21
Figure 3 Distribution of Foreign Shares in Chinese Listed Companies 1999 -
2008 25
Figure 4 Related-party Transactions in Companies Listed on Shanghai Stock
Exchange 28

Figure 5 Distribution of Related Parties of Shanghai-listed Companies
involved in Related-party Transactions (2005) 28
Figure 6 Amount of Funds Misappropriated by Dominant Shareholders in
Shanghai-listed Companies 2003 - 2005 30
Figure 7 Ownership Pyramid of Guangzhou Nanhuaxi Industrial Corporation
34
Figure 8 Fund Misappropriation Transactions between Nanhuaxi Industrial
Corporation and Its Dominant Shareholder or Affiliates of the Dominant
Shareholder 34
Figure 9 Average Number of Shareholders' Meeting in Chinese Listed
Companies 2001 - 2008 38
Figure 10. Distribution of Independent Directors' Opinions 112





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LIST OF SYMBOLS

ADR
American Depository Receipt
CEO
Chief Executive Officer
CSMAR
China Stock Market and Accounting Research
CSRC
China Securities Regulatory Commission
IPO

Initial Public Offering
NYSE
New York Stock Exchange
OECD
Organization for Economic Co-operation and Development
R&D
Research & Development
RMB
Renminbi
ROE
Return on Equity
SCSC
State Council Securities Commission
SEC
Securities and Exchange Commission

SOE
State-owned Enterprises

1

CHAPTER 1 – INTRODUCTION

1.1 Overview
Corporate governance issues arise in an organization whenever the
following two conditions are present: first, there is an agency problem
involving members of the organization which might be owners, managers,
workers or consumers; second, transaction costs are such high that this agency
problem cannot be dealt with through a contract (Hart, 1995).
In recent years, corporate stakeholders and academic scholars have
expressed strong concern about dominant shareholders‟ expropriation of
minority shareholders (La Porta, Lopez-de-Silanes, & Shleifer, 1999). Johnson,
La Porta, Lopez-de-Silanes and Shleifer (2000) use the term “tunneling” to
define the transfer of assets and profits out of firms for the benefit of their
dominant shareholders. Tunneling can take many forms, including outright
theft or dilutive share issues that discriminate against minority shareholders.
Such activities are perceived to be particularly serious in companies with a
concentrated ownership structure, or in countries where there is a thin market
for corporate control (Dyck & Zingales, 2004), or in countries where there is
poor or weak legal protection for investors (Nenova, 2003).
The corporate governance and financial economics literature have
started to explore the effectiveness of institutional mechanisms in preventing
dominant shareholders from engaging in expropriation activities (Johnson et al,
2000; La Porta, Lopez-de-Silanes, & Shleifer, 2002). Some researchers have
examined performance consequences of the dominant shareholders‟
expropriation activities (Atanasov, 2005; Dyck & Zingales, 2004). However,

only a few studies have examined how internal corporate governance

2

mechanisms, such as CEO incentive arrangements (Beatty & Zajac, 1994) and
a structurally independent board of directors (Claessens, Djankov & Lang,
2000; Rajan & Zingales, 2003), can mitigate the agency conflicts between
minority shareholders and dominant shareholders.
Much of the corporate governance literature draws insights from the
agency theory and examines the impact of ownership structure and ownership
concentration on the dominant shareholders‟ expropriation behavior. Although
some posit that high cash-flow rights provide dominant shareholders with too
much discretionary power over resource allocation and permit them to capture
private benefits at the expense of small shareholders (Bennedson &
Wolfenzon, 2000; Burkart, Gromb, & Panunzi, 1998), others point out that
high cash-flow rights motivate dominant shareholders to monitor managerial
behavior and distribute dividends (Jensen & Meckling, 1976). Moreover, in
companies which have several significant shareholders, non-dominant large
shareholders may form a coalition against the dominant shareholder and that
coalition could constitute a functioning mechanism to protect the interests of
small investors once it obtains sufficient voting rights (Bennedsen &
Wolfenzon, 2000; La Porta et al, 1999).
At the heart of the corporate governance reform is the common interest
on the effectiveness of the board of directors. Williamson (1985) argues that
the board of directors is primarily a governance structure safeguarding
between firms and owners of equity capital. As the highest internal control
mechanism responsible for monitoring the actions of corporate insiders (Fama
& Jensen, 1983), the board of directors may either curb or take a blind eye to
the expropriation activities initiated by corporate insiders. Academic research

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has largely focused on examining how specific dimensions of board structure,
such as the proportion of independent directors (Beasley, 1996; Hermalin &
Weisbach, 1991, 2001) and the separation of CEO and board chair positions,
can affect the relative power and decision-making tendencies in the CEO-
board relationship in widely-held companies in developed countries
(Finkelstein & Hambrick, 1989; Mallette & Fowler, 1992). For example,
adopting insights from the structuralistic view of power, some researchers find
that corporate boards that are structurally more independent from the
management are better able to control management decision-making on behalf
of the shareholders (Fama & Jensen, 1983; Westphal, 1998). However, little is
known on this issue with regard to companies with a concentrated ownership
structure where the agency conflict between the dominant shareholder and
minority shareholders prevails over the conflict between managers and
shareholders (Shleifer & Vishny, 1997).
For independent directors, the performance of the companies they
oversee has almost no impact on their personal wealth because they have
limited ownership stake in these companies (Hambrick & Jackson, 2000;
Patton & Baker, 1987) and they only receive a fixed amount of director fee.
The inconsistent findings on the association between the number/percentage of
independent directors and corporate financial performance (MacAvoy &
Millstein, 2003) suggest that independent directors can‟t effectively safeguard
the interests of shareholders without appropriate motivation, intellectual
capital and independence. Therefore, the question of how to improve the
effectiveness of independent directors draws increasing attention from the

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academia and the media, especially in the wake of various corporate

governance scandals.
This dissertation aims to explore two sets of questions: how do
corporate ownership structure and directors‟ affiliation with the dominant
shareholder affect the incidence of the dominant shareholder‟s expropriation
activities and the cost of these activities to listed companies? And what are the
arenas and sources of independent directors‟ challenging involvement in
corporate decision-making?
The empirical context for this dissertation covers all companies listed
on the Shanghai Stock Exchange in 2004 and 2005. Choosing a large sample
of listed companies in a single emerging economy rather than using cross-
country data is relevant to my research questions. In contrast to cross-country
analysis investigating the potential that a country‟s laws offer for the
protection for non-controlling shareholders from being expropriated
(Claessens et al., 2002; La Porta et al, 1998, 2002), this dissertation takes an
in-depth approach by analyzing firms that each face the same set of legal
restrictions, but have chosen to adopt different ownership structure and
governance practices.
The China stock market was initially established by the government to
partially, and eventually fully, privatize its state-owned enterprises (SOEs). As
the privatization of state-owned equities goes on, more shares are held in
private hands, and an increasing number of stakeholders are willing to take an
active role in monitoring dominant shareholders‟ behavior. By the end of 2008,
the China stock market had 1,604 domestically listed companies and a market
capitalization of RMB 12.14 trillion (approximately USD 1.78 trillion).

5

Concentrated ownership structure is a prominent organizational form (Firth,
Fung, & Rui, 2006; Mesngistae & Xu, 2004). The dominant shareholder is
usually the state or a legal entity, although there are a growing number of

cases where the dominant shareholder is a private firm or an institution.
There are some weaknesses in the regulatory framework in China with
respect to the agency conflicts between corporate insiders and minority
shareholders and the effectiveness of corporate boards (Ho, 2002; Lin, 2000).
First, the China Securities Regulatory Commission (CSRC) lacks both the
necessary resources and the power of investigation and prosecution to
effectively execute its rules and regulations. For example, national laws
including the Company Law and Securities Law have general provisions on
directors‟ duties and civil liabilities, which can only be solved by
administrative directives released by the CSRC. If a case on suspected
infringements is brought to the courts, the courts are not subject to the
Guidance Opinions released by the CSRC. Second, access to listing in China‟s
stock market is strictly administered by governmental authorities, and the
regulations are asymmetrically in favor of SOEs and other companies that
hold close ties to the government. As a result, although the CSRC issued the
Guidance Opinion on the Establishment of An Independent Director System in
2001, board independence is greatly compromised by the dominance of state
representatives on the board.

1.2 Research Questions
To explore how ownership structure and the board of directors
influence the level of agency conflicts between the dominant shareholder and
minority shareholders, and to investigate ways to enhance the challenging

6

engagement of independent directors in corporate decision-making, this
dissertation addresses two questions in the context of China‟s capital market.
 How do ownership structure and directors‟ affiliation with the
dominant shareholder affect the incidence of fund misappropriation

transactions initiated by the dominant shareholder and the cost of
these transactions to the listed company?
 What are the arenas and sources of independent directors‟
challenging involvement in corporate decision making?
Chapter 3 addresses the first question. By integrating the agency theory
and the social embeddedness perspective, I investigate the impact of state
ownership, foreign blockholders as well as affiliated directors on the dominant
shareholders‟ expropriation activities.
Regressions using archival data on all Shanghai-listed companies over
the period 2004-2005 lend support to the predictions that the incidence of a
dominant shareholder‟s expropriation activities decreases with the presence of
foreign blockholders and increases with the percentage of affiliated directors;
and the cost of these expropriation activities to the listed company increases
with the level of state ownership. Additional analyses are performed regarding
the impact of foreign retail investors, the dominant shareholder‟s portfolio
considerations and the interaction between the dominant shareholder and other
large shareholders.
The second question is examined in Chapter 4. Previous studies have
concluded that independent directors are expected to effectively constrain
corporate insiders from instigating and perpetrating frauds, discipline CEOs in
firms with poor performance, and influence the processes of strategic choice,

7

change and control. However, in addition to their limited power, independent
directors are confronted with persistent challenges in making meaningful
contribution to corporate decision making. As a response, I examine to what
extent the challenging involvement of an independent director in corporate
decision making depends on the availability of the director‟s intellectual
capital, social influence received from corporate insiders, and the individual‟s

organizational power. Based on the insights from previous studies and
independent directors‟ responsibilities in China, I specify three arenas of
corporate decisions on which an independent director is expected to deliver
challenging opinions: “monitoring executive performance”, “protecting
corporate resources”, and “providing counsel to executives”. And I identify
the matches between the expected involvement of an independent director and
the required sources to provide such involvement, and explore how an
independent director‟s challenging involvement in different arenas affects the
individual‟s turnover in the focal company.
To conduct empirical analysis, I utilize a sample of 2,806 independent
directorships from all Shanghai-listed companies in 2005. The findings
suggest that the intellectual capital structure and social context of independent
directors deliver a significant impact on these directors‟ challenging
involvement in the three arenas of corporate decision-making. By examining
the determinants and consequences of social influence and reciprocity, I
suggest that micro-social factors involved in the relationship between
corporate insiders and independent directors, by affecting the delivery of
independent directors‟ independent and challenging opinions on key corporate
decisions, ultimately compromise corporate control.

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1.3 Contribution
In addition to the individual contributions made by each chapter as
outlined above, this dissertation makes the following overall contributions.
First, previous studies on the board of directors have relied on the agency
theory and favor the board of directors‟ control role at the expense of its
service and strategic roles (Hillman & Dalziel, 2003). In this dissertation, I
propose a multiple lens‟ approach to obtain a richer understanding of the
influence of corporate directors, and independent directors in particular.

Because of the rather confidential nature of board activities, I measure
independent directors‟ performance by identifying various board decisions that
relate to their roles and responsibilities.
Second, previous literature has found that dominant shareholders‟
expropriation of minority shareholders result in consequences such as a higher
premium for voting shares (Nenova, 2003; Zingales, 1994), fewer IPOs (La
Porta et al, 1997), a lower company valuation (Claessens et al, 2000; La Porta
et al, 1999), and an inefficient allocation of investments (Wurgler, 2000). This
dissertation takes the lead to explore how internal governance mechanisms
including ownership structure and the board of directors influence the level of
agency conflicts between the dominant shareholder and minority shareholders,
in a setting situated in an emerging economy.
Much of the academic literature has attempted to measure the
expropriation of minority shareholders indirectly (Bertrand, Mehta &
Mullainathan, 2002; Claessens et al, 2002; Faccio, Lang & Young, 2001; La
Porta et al, 2000b, 2002). Consequently, there is little direct and systematic
evidence on the specific transactions through which such expropriation occurs.

9

This dissertation adds value to the literature by using fund misappropriation
transactions initiated by the dominant shareholder as a proxy for that
shareholder‟s expropriation behavior and examines both the incidence of such
transactions and their costs to listed companies.
Finally, previous studies emphasize the impact of specific changes in
board structure on corporate outcomes such as CEO compensation, corporate
diversification and firm performance (Hermalin & Weisbach, 1991; Westphal
& Zajac, 1994). However, this dissertation devotes sufficient attention to the
black box of board process, and emphasizes the roles of individual
characteristics and social context in determining the performance of

independent directors. Furthermore, this dissertation integrates our
understanding of the various arenas in which independent directors can exert
valuable influence, and identifies the need for a match between the expected
challenging involvement of independent directors, and the required intellectual
capital and organizational power to initiate these involvements.

1.4 Organization of Dissertation
This chapter provides an overview of the two essays discussed in this
dissertation. It states the major contributions of this dissertation to the
corporate governance literature and to the theoretical developments in
strategic management and organization theory. Chapter 2 begins by discussing
the institutional environment concerning China‟s state-dominated capital
market, ownership structure of listed companies and the most prominent
problem associated with it, which is the fund misappropriation transaction
between a listed company and its dominant shareholder, and then proceeds to

10

discuss the institutions of the board of directors and the supervisory board as a
potential solution to the corporate governance problems in China. Chapters 3
and 4 address the two research questions respectively. I present each of the
two essays as a complete empirical paper that could potentially function as a
stand-alone piece of research.

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CHAPTER 2 – INSTITUTIONAL ENVIRONMENT

Corporate governance is a broad subject, intertwined with many areas
of financial reform. The western concept of corporate governance centers on

the principles of transparency, accountability, and fairness. And the main
mechanisms of corporate governance to look for include an independent board
of directors, treatment of minority shareholders, and coordinating the interests
of shareholders and corporate executives.
Currently, the main agency problem in the U.S. and U.K. is between
the management and outside diverse shareholders where managers pursue
private benefits at the cost of the shareholders‟ interests. In continental Europe
and Japan, ownership is highly concentrated in the hands of main banks and
financial institutions. In East Asian economies where ownership is highly
concentrated in the hands of controlling families, dominant shareholders are
able to pursue self-interests via unchecked related-party transactions or abuses
of corporate assets, which make the main agency conflict exists between the
dominant shareholder and minority shareholders.
This dissertation uses China as the institutional setting. With the
continuous corporatization of state-owned enterprises (SOEs), rapid expansion
of the stock market and the ever increasing market awareness, coupled with a
series of giant corporate scandals and accounting failures, corporate
governance has become a very pressing problem in China. Many governance
mechanisms that firms in the U.S. utilize, such as monitoring from strategic
investors, external takeover threat, and managerial ownership, are uncommon
among Chinese firms (Tam, 2002). And the main agency problem exists
among multi-parties including state shareholders, directors, supervisors,

12

executives and minority shareholders. Thus, the choice of China complements
previous studies on corporate governance that were conducted in the context
of Anglo-American economies. Furthermore, it allows me to focus on the
impact of internal governance mechanisms due to the limited impact of
external governance mechanisms such as the market for corporate control. In

contrast to cross-country analysis that investigates how national laws influence
board effectiveness and protect shareholders‟ rights, this dissertation takes an
in-depth approach to analyze firms that each faces the same set of legal
restrictions, but has chosen to adopt different ownership structures and
governance practices.
After a brief description of the institutional environment concerning
the development of China‟s capital market, this chapter discusses corporate
ownership structure and one of the most prominent problems associated with it,
which is the fund misappropriation transaction between a listed company and
the company‟s dominant shareholder. Then it proceeds to discuss the
institutions of the board of directors with a special focus on independent
directors, and the supervisory board. This chapter concludes with the
discussion of potential contributions of China-based studies to the general
development of corporate governance research.
2.1 The Development of China Stock Market
It is virtually impossible to understand the emergence of China‟s
corporate governance system without putting it into the broader context of the
1990 economic reform. Before the 1990s, economic reforms in China involved
the corporatization of SOEs and the adoption of profit-making objectives such
as contract responsibility systems. While the government delegated increasing

13

autonomy to managers of the corporatized SOEs, it was unwilling to give up
ownership rights. Political interference in business operations was rife and
managers‟ autonomy was emasculated (Firth, Fung & Rui, 2002). As a result,
SOEs performed below the expectation of the government. At the same time,
backward equipments and facilities of SOEs motivated the government to seek
a great amount of capital to facilitate the reforms of these companies.
The China stock market was initially established by the government to

partially, and eventually fully, privatize its SOEs. As the privatization of state-
owned equities continued, an increasing number of companies became listed
on the Shanghai and Shenzhen Stock Exchanges after 1990. To be listed and
thus become eligible to raise capital directly from the public, a company must
take the form of a joint stock company under the Company Law - a form
intended for large corporations with a widely dispersed ownership structure.
Companies can also go public on overseas exchanges, typically in Hong Kong
and New York.
Apart from the government-controlled regulatory framework that is in
contrast with the administratively independent regulatory bodies in the U.S.
and U.K., the state monopolizes the access to equity finance in the sense that it
has the final say on which firm is qualified to raise equity funds through IPOs.
A firm needs to demonstrate three continuous years of profits in order to be
qualified as a candidate for listing. The state sets a quota for the number of
listings each year and the listing selection process involves various social and
political considerations (Chen et al, 1998), which are often asymmetrically in
favor of SOEs and other firms that hold close ties to the government. For this
historical reason, the majority of Chinese listed companies originate from

14

restructured SOEs and the government still holds a majority of shares in these
companies, either by direct shareholding or indirectly through state-owned
institutions such as state investment firms, state holding firms, and state asset
management agencies (Chen, 2004).
By the end of 2008, the China stock market had 1,604 domestically
listed companies and a market capitalization of RMB 12.14 trillion
(approximately USD 1.78 trillion). The dominant shareholder is usually the
state or a legal entity (Firth, Fung & Rui, 2006), although there are a growing
number of cases where the dominant shareholder is a private firm or an

institution. Table 1 illustrates the development of the China stock market over
the period 1998 to 2008.
Table 1 An Overview of China Stock Market 1998 - 2008

Source: Shanghai Stock Exchange, Shenzhen Stock Exchange