Department of International Economics & Business Master Thesis
AN EMPIRICAL STUDY ON THE INFLUENCE OF MUTUAL FUNDS ON THE BOARD OF DIRECTORS IN CHINESE LISTED FIRMS
Frederik de Graaf Student number: S1607421 Frederikdegraaf@hotmail.com
Thesis Supervisor Co-Assessor
Prof. Dr. Hans van Ees Dr. Robert Inklaar
May – 2014
Abstract: Mutual funds are actively targeted by Chinese authorities to improve corporate governance in listed Chinese firms. In my thesis I investigate the influence of mutual funds on the boards of directors in Chinese listed firms. Using a panel dataset I find no evidence that mutual fund ownership is associated with better corporate governance with respect to the board of directors. These findings provide new insights into the influence of mutual funds on the board by directly investigating this relationship in the Chinese context, and it helps assess whether Chinese policy encouraging mutual funds to improve corporate governance has effect on the board of directors. This thesis fills a gap in the literature by directly investigating the influence mutual funds have on corporate governance, which has not been done until now.
Keywords: China, board of directors, mutual funds
Table of Contents
1. Introduction ... 1
2. Context of the analysis ... 3
2.1 Legal and regulatory framework for the board of directors ... 3
2.2 Shares ... 4
2.3 Ownership ... 5
2.4 Mutual funds ... 6
3. Theory and hypothesis development ... 8
3.1 Theory... 8
3.2 Hypotheses ... 11
4. Methodology ... 15
4.1 Data ... 15
4.2 Variables ... 15
4.2.1 Dependent variables ... 16
4.2.2 Independent variables ... 16
4.2.3 Control variables ... 17
4.3 Method ... 20
4.4 Model specification ... 21
5. Results ... 22
5.1 Descriptive statistics and the correlation table... 22
5.2 Factor analysis ... 23
5.3 Final model specification ... 25
5.4 Regression results ... 26
6. Discussion... 30
6.1 Summary of findings ... 30
6.2 Implications ... 31
6.3 Limitations and directions for future research ... 32
References ... 34
Appendix 1: Firms and financial reports in the sample ... 38
1 1. Introduction
Over the past three decades the Chinese economy has been in a process of transition. In this period China moved from a planned economy to a market-oriented economy, through processes of liberalization, enterprise reform and privatization (Hoskisson, Eden, Lau & Wright, 2000). In the process of privatization, the change in ownership can give rise to agency problems such as managerial perquisite consumption and entrenchment. This makes corporate governance a key issue in the reform process (Dharwadkar, George & Brandes, 2000). The reason for this is that corporate governance deals with how providers of capital deal with principal-agent problems and seek to assure themselves of receiving a return on their investment (Shleifer & Vishny, 1997). A key role in corporate governance is reserved for the board of directors (Jensen, 1993), and the board has been targeted by policies of the China Securities Regulatory Commission (CSRC) aimed at improving corporate governance in Chinese listed firms (Chen & Al-Najjar, 2012;
Yang, Chi & Young, 2011). The CSRC also sees a special role for mutual funds in improving corporate governance of listed firms and encourages mutual funds in this role (Yuan, Xiao, Milonas & Zou, 2009). These two policies rest on the assumption that mutual funds influence corporate governance and that the board of directors is an important corporate governance mechanism in China. This second assumption has a foundation in the literature (Chen, Firth, Gao
& Rui, 2006; Fan, Lau & Young, 2007; Chen & Al-Najjar, 2012; Kato & Long, 2006), but the influence mutual funds have on the corporate governance of listed firms has not yet been investigated (Yang et al. 2011). The evidence for the importance of the board provides a way to find evidence for the first assumption by looking at the board of directors by answering the question: Do mutual funds influence the boards of directors of Chinese listed firms, and if so, what drives them to target specific board characteristics and how do they exert their influence?
To answer this question I will investigate the influence mutual fund equity ownership has on several aspects of the board of directors such as board size and composition in Chinese listed firms. This is a topic which has received little attention in the literature so far (Chen & Al-Najjar, 2012). An extensive literature treats the determinants of board size and composition in western countries such as the US (Boone, Karpoff & Raheja, 2007; Hermalin & Weisbach, 1988), Italy (Barucci & Falini, 2005), and the UK (Guest, 2008). The relationship is further investigated as part of more general studies on corporate governance using indices which include board
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characteristics (Bhagat, Bolton & Romano, 2008; Klapper & Love, 2002). What the literature shows is that these determinants differ because of the different environments in these countries, which give rise to different corporate governance problems (Barucci & Falini, 2005; Guest, 2008). China in particular is recognized as different and in Chinese boards we see elements of both the German and US system as well as features unique to China (Tam, 2002).
The literature recognizes ownership as an important determinant of board size and composition for Chinese listed firms (Chen & Al-Najjar, 2012). Ownership by blockholders is recognized as a determinant of board characteristics (Barucci & Falini, 2005; Chen & Al-Najjar, 2012), with an important role reserved for institutional investors (Barucci & Falini, 2005; Davis, 2002). For mutual funds there is evidence that they influence board characteristics in the US (Morgan, Poulsen, Wolf & Yang, 2011). For China evidence for their influence only comes in the form of side notes to studies on the ownership-performance relationship (Yuan, Xiao & Zou, 2008), or in studies on the more general institutional ownership-corporate governance relationship (Yuan et al., 2009).
A direct study of the mutual fund-board relationship in China has thus far not been undertaken (Yang et al., 2011). As argued by Guest (2008) for the UK and recognized for China by Chen &
Al-Najjar (2012), an investigation such a relationship in for China will contribute to a better and broader understanding of how ownership helps determine board characteristics by providing a comparison for other studies and by highlighting factors which do not commonly play a role in the literature on Western firms. I expect my analysis to yield insights in two ways. First, it will provide insights into factors in this relationship that are unique to China. Second, I will assess whether known factors play the same role in a different context and thus seek to verify existing theory. A further contribution lies in the fact that this analysis also covers the aforementioned assumption on which the CSRC’s policy of encouraging mutual funds to improve corporate governance is based.
The remainder of my thesis is organized as follows: In section two I will outline the context of my thesis in as far as it is specific to China. In section three I will outline my theoretical model and propose testable hypothesis. Section four will discuss the methods and data used to test these hypothesis. The results of the analysis will be presented in section five, followed by a discussion in section six.
3 2. Context of the analysis
China offers a unique context for the analysis of corporate governance problems. The Chinese system differs from western systems in that it has emerged from a planned economic system.
China also differs from other transition economies such as those in Eastern Europe in that it has gone through economic transition, but not political transition. The current Chinese corporate governance system has foreign features taken from the Anglo-Saxon and German systems, as well as Chinese features (Tam, 2002).
2.1 Legal and regulatory framework for the board of directors
The legal framework for the board of directors of listed Chinese firms is provided by The Company Law of the People’s Republic of China (2006). Unlike its predecessor which mostly prescribed fixed structures, the company law of 2006 gave companies more freedom in setting up their corporate governance system (Dickinson, 2013). This has given companies room to implement those corporate governance structures they prefer rather than having to use a fixed system. Further regulation is provided by the CSRC, which issued a code of corporate governance for listed companies in China in 2001 to set a standard for Chinese corporate governance (CSRC, 2001).
Chinese boards are two-tiered, with a board of directors and a board of supervisors. Both of these boards are appointed by the general assembly of shareholders and report to the shareholders. The Chinese company law of 2006 gives the board of directors powers relating to financial planning, profit distribution, capital structure, company structure, management structure, hiring and firing of managers, and any other functions it is given by the articles of association (Company Law of the People’s Republic of China, 2006, Article 47). The board of supervisors’ tasks are checking the company’s financial affairs and supervising directors and senior management. The supervisory board can make a proposal to fire directors or managers, to convene shareholders’
meetings, and investigate the actions of the board or managers (Company Law of the People’s Republic of China, 2006, Articles 54, 55). Unlike in the German and Japanese systems, these two boards exist at the same hierarchical level. The board of supervisors has very little actual authority, and it has been criticized as being ineffective to the point where it is argued that the Chinese system is more like the Anglo-Saxon system (Dahya, Karbhari & Xiao, 2002). This
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means the task of monitoring falls mainly on the board of directors, which makes independent directors especially important (Chen & Al-Najjar, 2012).
2.2 Shares
There are four different classes of shares in Chinese companies. These classes of shares differ in where they are listed and the currency in which they are denominated. A-shares are shares denominated in Yuan and listed on the Shanghai Stock Exchange (SSE) or Shenzhen Stock Exchange (SZSE). B-shares are denominated in foreign currency and listed on the SSE or SZSE.
N-shares are listed on US exchanges such as the New York Stock Exchange. H-shares are listed on the Hong Kong Stock Exchange (HKSE).
H-shares are in many cases registered to the name of the Hong Kong Securities Clearing Company Nominees Limited (HKSCC) which sells the rights to these shares to investors.
Foreign investors can exercise their voting rights through the HKSCC and will receive their dividends through the HKSCC. The HKSCC also serves as a channel through which foreign investors receive information. This means the HKSCC has a degree of control over the voting, as not all investors may exercise the right to vote themselves and because they control at least part of the information investors receive. Unfortunately the HKSCC also shows up as a single owner in ownership data, which means data on ownership concentration will be overstated.
Limits on exchange of the Chinese Yuan and a high savings rate have fuelled domestic demand for investment and have led to price differences between the different share classes, with A- shares trading at a premium. Foreign investors can trade in H-shares or N-shares, but access to the Chinese domestic market and thus A-shares and B-shares is restricted to Qualified Financial Institutional Investors (QFIIs). This means investors place different values on the different shares, and foreign owners of domestic shares are sophisticated investors. Domestic investors are highly exposed to the domestic market, and may therefore prefer stronger monitoring.
A further distinction between share types lies in their tradability, and many shares cannot be freely traded. Owners of shares that cannot be freely traded may be motivated to monitor the company to which their holdings are exposed more intensively (Maug, 1988). They may, however, also place a lower value on their shares as they cannot benefit from capital gains and thus pursue goals other than value maximization. This creates a further need for strong corporate
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governance to protect other investors, as non-freely tradable shares are often held in large blocks.
Even though the system of non-tradable shares has been reformed in the period from 2005 to 2006, non-tradable shares still account for a substantial, but decreasing, proportion of Chinese shares. The Chinese state is the main owner of non-tradable shares.
2.3 Ownership
Ownership in Chinese listed firms is highly concentrated. This creates the risk that controlling shareholders may use their power to expropriate wealth from other investors (Yuan et al., 2008).
In addition to monitoring management, corporate governance structures in China thus also serve to monitor large shareholders (Yang et al., 2011). Shareholder concentration leaves controlling shareholders with substantial influence over the way the board of directors is organized (Lin, 2004; Clarke, 2006).
The Chinese state is a major shareholder in listed firms, often holding a controlling share. The state may have objectives different from other shareholders and may use its power to achieve political objectives. The state may also simply remain passive (Lin, 2004), which leaves larger responsibility to management and thus increases the importance of the board as a monitoring body (Chen & Al-Najjar, 2012). State ownership may also have a positive influence of corporate governance as the State-Owned Assets Supervision and Administration Commission has set itself the goal of improving corporate governance. Ownership by the central government has indeed been associated with better performance and it has been suggested this is the result of better corporate governance (Xia & Zu, 2009). In recent years the proportion of shares held by the state has decreased, but the Chinese state still maintains a controlling share in many firms.
Foreign ownership in Chinese firms is limited, as foreigners can trade H- and N-shares, but are restricted in their access to the domestic Chinese market. Access to the domestic market is restricted to QFIIs which are allotted individual quotas limiting the amount they can invest in the domestic market. In March 2012 QFIIs held quotas worth 24.55 billion and this was raised by 50 billion on March 23rd. QFII holdings represented 1.09% of freely floating A-shares in terms of market capitalization at this time (CSRC, 2012). The number of QFIIs had increased to 206 by the end of 2012 (CSRC, 2014). This means only a limited number of shares issued by Chinese
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companies are accessible to foreign owners and foreign ownership is thus restricted to these shares.
2.4 Mutual funds
The market for Chinese mutual funds has grown rapidly in response to the high demand for professional investment management which has resulted from China’s high savings rate. Chinese mutual funds serve as a means for individual investors to solve collective action problems and hire professional fund managers. With their investments pooled investors have more leverage to influence corporate governance rather than vote with their feet. They also have professional fund managers to represent their interests. The rapid growth of the mutual fund market has been followed by regulatory efforts by the CSRC to encourage mutual funds to play their role as a
“pillar” in Chinese corporate governance (Yuan et al., 2008).
The legal framework for Chinese mutual funds in the period covered by my thesis is provided by the Law of the People’s Republic of China on Funds for Investment in Securities of 2003. This law was revised in 2012 and the new law came into effect in 2013. The law mainly regulates the relationship between investor and mutual fund. Under the 2003 law, foreign firms could not directly offer fund management services on the Chinese domestic market, and had to do so through minority positions in joint ventures with local firms. This means that some domestic mutual funds over this period benefited from foreign expertise and funds. It must be noted that foreign mutual fund could still own stock on behalf of their foreign clients, both on the domestic market as QFIIs and in the form of H-shares and N-shares.
Expropriation of minority shareholders is a central problem when corporate governance and investor protection are weak and ownership is concentrated (La Porta, Lopez-de Silanes, Shleifer
& Vishny, 2000). This is also a problem in Chinese corporate governance, which gives Chinese mutual funds a role in monitoring controlling shareholders (Yuan et al., 2008). Mutual funds are also encouraged to play this role by the CSRC (Yang et al., 2011). A motivation for mutual shareholders to perform this role is that they are themselves relatively small shareholders compared to the major shareholders in Chinese firms. This distinguishes mutual funds in China from mutual funds in the west, which are relatively large shareholders.
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Under the previous company law, an investor also benefited from investing in a mutual fund due to the absence of a proxy voting system (Yuan et al., 2008). This made many investors free riders and they did not use their votes. The new Chinese company law of 2006 has addressed this issue, and article 107 states that investors are allowed to vote by proxy.
8 3. Theory and hypothesis development
3.1 Theory
Shleifer & Vishny (1997) define corporate governance as “the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. In this view the board is an answer to a principal-agent problem where the board monitors managers, the agents, on behalf of the shareholders, the principals, to ensure managers make decisions in the interest of shareholders rather than their own interests. In this role the board has two main functions (Adams, Hermalin & Weisbach, 2010). First, boards are involved in the hiring, firing and monitoring of a firm’s upper management. Second, boards are involved in setting strategy, and they provide advice to management. This has raised two questions about boards. First of all, how effective are they, and second, what determines their effectiveness.
To assess board effectiveness, one would like to measure how boards perform their role, but it is difficult to measure differences in behavior (Adams et al., 2010). The reason for this is that it is difficult to obtain data because this would require access to board rooms as well as a method for capturing board behavior in a quantitative manner for statistical analysis. As a consequence, much research focuses on structural and other differences that lead to differences in behavior (Hermalin & Weisbach, 2001). Two such measures which are commonly used are the size and composition of the board (Boone et al., 2007). Other distinctions are made based on CEO duality and the appointment of directors (Adams et al., 2010). Further distinctions come in the form of director shareholding and compensation (Adams et al, 2010; Cosh, Guest & Hughes, 2006). A last distinction is made based on board activity (Barucci & Falini, 2005).
Several theoretical frameworks have been developed in the literature to explain the differences between boards in terms of their characteristics. Boone et al. (2007) suggest boards arise in response to a firm’s needs, a trade-off between the benefits and costs of monitoring, and as a result of the relative power of the CEO and outside board members. A further explanation of differences between boards is provided by Guest (2008), who shows boards vary with the institutional settings in different countries. A further reason for variation is provided by Adams et al. (2010), who argue boards arise in heterogeneous circumstances that constrain companies in how they can set up their board. Another factor influencing the board is ownership. Different
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owners of shares in firms have different objectives and preferences and capabilities and will thus differ in how they exercise their control rights with respect to voting on issues related to the board (Chen, Firth & Xu, 2009).
The literature suggests two aspects of ownership as determinants of board characteristics. The first of these is ownership concentration. Dispersed ownership creates collective action problems for shareholders due to free-riding (Shleifer & Vishny, 1997), which affects their power to influence management. Blockholders on the other hand, have stronger incentives to be active shareholders if their shares are illiquid due to their high exposure to the fortunes of a single firm (Maug, 1988). The interests of blockholders may also differ from those of smaller shareholders, as they can use their voting power to expropriate wealth from smaller shareholders (Shleifer &
Vishny, 1997). The second aspect of ownership suggested by the literature is the identity of owners, which is theorized to affect their incentives and objectives, and thus their actions. The literature suggests several ownership identities which have interests that go beyond those associated with the size of their share. Examples are managers (Jensen & Murphy, 1990), directors (Bhagat & Bolton, 2008), the state (Chen & Al-Najjar, 2012), and institutional investors (Davis, 2002). Some of these owners may obtain rents beyond the return of their shares by using their influence to further other objectives. The state may pursue social or political objectives (Yang et al. 2011), or managers may wish to increase their own rents (Dharwadkar et al., 2000).
Institutional investors in particular receive attention for their capacity to improve corporate governance as their share in equity holdings and thus their power over firms is increasing (Davis, 2002). There are two mechanisms through which institutional investors can improve corporate governance. First of all they offer a solution to collective action problems in monitoring as they often hold a larger amount of shares, and their large holdings also gives them more leverage over management in enforcing their rights (Davis, 2002). Secondly, as sophisticated investors they can use their knowledge to improve a firm’s corporate governance structures (Morgan et al., 2011). Studies on the impact of institutional investors have yielded mixed results due to institutional investor heterogeneity (Chen, Harford & Li, 2007). This suggests that looking at specific institutional investors rather than the aggregate is more likely to yield results. It must also be noted that institutions typically do not try to obtain large stakes in single firms (Davis,
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2002). This suggests the chance of expropriation of minority shareholders by institutions is small.
A specific group of institutional investors targeted by CSRC policies to improve corporate governance are mutual funds. Mutual funds are collective investment schemes offered to the general public, which are professionally managed. In the literature there are two perspectives on the effect of mutual funds on corporate governance. Morgan et al. (2011) suggest two reasons why mutual funds could have a positive influence on corporate governance. First of all, mutual funds are pressured by regulators to play an active role in corporate governance. Regulators such as the Securities and Exchange Commission (SEC) in the United States (Morgan et al., 2011) and the CSRC in China (Yang et al., 2011) pressure mutual funds to improve corporate governance. Secondly, the size of their holdings can make them illiquid due to the potential price effects of selling, thus decreasing the ability of mutual funds to vote with their feet and increasing monitoring incentives (Chen et al., 2007). Mutual funds may further find themselves unwilling to sell if they base their investments on an index or seek to track an index rather than to invest in companies with good corporate governance (Morgan et al., 2011). Chinese mutual funds may further serve as monitors of other large shareholders given the high degree of ownership concentration. They provide a means for smaller investors to pool their funds, thereby strengthening their bargaining position, and an incentive to actively involve themselves in a firm (Yuan, et al., 2008).. Yuan et al. (2008) give two reasons for which mutual funds may not affect corporate governance. First, mutual funds may prefer to sell shares rather than engage in costly monitoring. Secondly, mutual funds may only be interested in beating certain benchmarks in the short-term. Another possible reason for a short-term focus is that mutual funds need to maintain liquidity as those that invest in mutual funds also have the option to opt out (Morgan et al., 2011).
Two other factors affecting the influence mutual funds can exert on corporate governance are the size of their individual and collective holdings and their position relative to other shareholders.
The larger the combined holdings of mutual funds, the larger their impact is likely to be, an effect which is even stronger when ownership by mutual fund is more concentrated. When mutual funds hold more shares they also risk higher losses when selling their shares, which provides an additional incentive for improving corporate governance (Maug, 1988; Morgan et
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al., 2011). This argument on collective holdings can be extended to their position relative to other shareholders, as a larger proportion of mutual funds among the major shareholders is more likely to see them have an impact on corporate governance.
Like other institutions, mutual funds that invest in equity are heterogeneous. This means they are likely to differ in the ways in which, and the degrees to which, they influence the board of directors. Distinctions between mutual funds which invest in equity are commonly made in terms of their investment strategies and size. Another distinction can be made between domestic and foreign mutual funds. Economic theory suggests that those firms that expand abroad are capable of doing so by being better at what they do than their domestic and foreign counterparts (Bernard, Jensen, Redding & Schott, 2007). I expect this to be the same for mutual funds, which means foreign mutual funds which invest in China are likely to be more sophisticated on average than their domestic competitors. They can be expected to be knowledgeable on best practice with respect to the board, and they can transfer this knowledge (Hasan & Xie, 2013).
3.2 Hypotheses
When owner identities influence the types of governance structures owners prefer in systematic and different ways, it is possible to make predictions about board characteristics based on the ownership structure of a company. Owners will use their influence to steer firms towards those governance structures they prefer, and we can thus expect to observe certain board characteristics when mutual funds own equity in a Chinese listed firm. In this section I will propose six hypotheses covering size, structure, director shareholding, and board activity.
There are two perspectives on board size in the literature. One suggests boards suffer from coordination and free rider problems as they increase in size. The other, the resource-based view, suggests additional directors bring additional resources to boards as it creates room for board members to specialize. Additional directors also help Chinese boards by connecting them to their own personal networks or so-called guanxi” (Liu, Atinc & Kroll, 2011). So in board size there is a tradeoff, as increased board size is associated with increased monitoring costs, but may also benefit the firm (Boone et al., 2007). If mutual funds thus exert a positive influence on corporate governance in Chinese firms, mutual fund ownership may be associated with either smaller or
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larger boards of directors, depending on which effect dominates. . This leads to my first hypothesis:
Hypothesis 1a: Mutual fund shareholding will be associated with larger boards in listed Chinese firms.
Hypothesis 1b: Mutual fund shareholding will be associated with smaller boards in listed Chinese firms.
In terms of board composition mutual funds will aim to get those directors on the board that best represent their interests. The literature distinguishes between two main types of directors, namely inside directors and outside directors. Inside directors have a stake in the firm other than their directorship whereas outside directors have no stake in the firm other than their directorship.
This means inside directors have a conflict of interests. Inside directors include directors such as executive directors or directors related to major shareholders. Outside directors are used as an indicator of board independence (Adams et al, 2010) and higher proportions of outsiders make it more likely poorly performing CEOs are fired (Fan et al., 2007; Kato & Long, 2006; Weisbach, 1988). It is considered important for a board to be independent because when a board is in the power of those that it is supposed to monitor it is less likely to be an effective monitor. Outside directors are also perceived as effective monitors by shareholders, and the addition of outside directors to boards increases share prices (Rosenstein & Wyatt, 1990). Mutual funds in China are often not major shareholders and thus unlikely to be able to get their own insiders on the board.
We can thus expect mutual funds to prefer more outside directors on boards, as insiders are likely to also represent either the managers the board is supposed to monitor or other major shareholders. Chinese law requires one third of the board of directors in listed companies to be composed of what it calls independent directors. The CSRC code of corporate governance for listed companies in China states that independent directors in Chinese listed firms can hold no other function than that of director at the company at which they are an independent director and that they must be independent from major shareholders. This leads to my second hypothesis:
Hypothesis 2: Mutual fund shareholding will be associated with a higher proportion of independent directors on the boards of directors of listed Chinese firms.
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Closely related to the number of outsiders is the number of insiders on the board. As mutual funds’ relatively small holdings are unlikely to get them their own insiders on boards, they are likely to wish to limit the number of insiders. A specific type of inside director whose number mutual funds are likely to wish to limit is the executive director as Chinese executive directors are linked to fraud (Chen et al., 2006). Having fewer executive directors also reduces the risk of agency problems such as managerial perquisite consumption and entrenchment (Dharwadkar et al., 2000). This leads to my third hypothesis:
Hypothesis 3: Mutual fund shareholding will be associated with a smaller proportion of executive directors on the boards of directors of listed Chinese firms.
Another measure of board characteristics is director compensation (Adams et al., 2010), which is used to influence director incentives so as to align them with shareholders’ interests. Board monitoring has been shown to be positively influenced by director shareholding (Bryan & Klein, 2004). Though directors may not have their incentives fully aligned with the interests of mutual funds by owning shares, for example because they are executive directors, ownership of shares goes some way in aligning their incentives with the interests of small shareholders by making them small shareholders. I therefore expect mutual funds to encourage director shareholding and forms of compensation that increase director shareholding. This leads to my fourth hypothesis:
Hypothesis 4: Mutual fund shareholding will be associated with more shares owned by the members of the board of directors of listed Chinese firms.
In addition to owning an amount of shares sufficiently large to influence director incentives, it is important that a sufficient number of directors own shares. The reason for this is that Chinese boards of directors vote on the principle of one vote per director (Company Law of the People’s Republic of China, Article 112). This means a non-shareholding majority can otherwise outvote shareholding directors. This leads to my fifth hypothesis:
Hypothesis 5: Mutual fund shareholding will be associated with a higher proportion of shareholding directors on the board of directors in listed Chinese firms.
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A last measure proposed by Barucci & Falini (2005) is board meetings. They argue a board that meets more often is a more active monitor, and thus likely a better monitor. Mutual funds will prefer more intensive monitoring of management and major shareholders by boards, and thus encourage boards to be more active. This leads to my sixth hypothesis:
Hypothesis 6: Mutual fund shareholding will be associated with more active boards in Chinese listed firms.
15 4. Methodology
4.1 Data
In my thesis I seek to analyze Chinese listed firms. In order to obtain a sample of such firms I obtained a list of 664 firms listed from the Shenzhen Stock Exchange website and a comparable list of 664 companies for the SSE using the Bureau van Dijk Orbis database. This resulted in an initial sample of 1328 companies, equally divided between mainland China’s main two exchanges. I then refined these lists based on 2 criteria. First, companies had to be listed on December 31st, 2012. Second, companies had to have annual reports for 2012 available in English. I then proceeded to collect additional annual reports for 2006 and 2009. I had two reasons for choosing these years. First of all, the new Chinese Company Law came into effect in 2006, and using years after 2006 thus keeps the legal environment constant. The previous legal environment also left much less room for variation in company charters and thus governance structures (Dickinson, 2013). Secondly, choosing to use reports 3 years apart allows me to cover more companies and a longer period given time constraints on data collection. In addition to that, directors are commonly elected for multi-year terms. The length of a director’s tenure is set by the articles of association and the Chinese Company Law sets a maximum of three years for terms (Company Law of The People’s Republic of China, Article 46) Ownership changes are also likely to be more substantial over periods of three years rather than one year. In total, 213 annual reports were collected. Additional data was collected using investor services websites.
The source for ownership statistics were the tables listing the top ten shareholders in the reports.
This process resulted in a final sample of 171 observations for 81 companies for which all information needed was available. A list of all companies and reports is provided in appendix 1.
4.2 Variables
In this section I will discuss all the variables I will use to construct the model with which I will test my hypotheses.
16 4.2.1 Dependent variables
Board size. The Chinese company law requires companies to have at least 5 directors and at most 19 directors. I will measure the size of Chinese boards as the number of directors over five on the board on December 31st of 2006, 2009 and 2012.
Independent directors. Independent directors are specifically listed as such in the annual reports of listed Chinese firms. Chinese law requires at least one third of board to be composed of independent directors. I will measure independent directors as the proportion of independent directors on the board on December 31st of 2006, 2009 and 2012.
Executive directors. There are no restrictions on the number of executive directors that can sit on Chinese boards other than the limit that follows from the minimum number of independent directors. I will measure executive directors as the proportion of executive directors on the board on December 31st of 2006, 2009 and 2012.
Shares held by directors. I will measure the number of shares held by directors as the natural logarithm of the total of shares held by all directors on December 31st of 2006, 2009 and 2012.
Shareholding directors. I will measure the number of shareholding directors as the
proportion of directors holding shares on December 31st of 2006, 2009 and 2012.
Board meetings. I will measure the number of board meetings as the number of board
meetings in the period covered by each annual report.
4.2.2 Independent variables
Mutual fund ownership. I will measure ownership by mutual funds in five ways in order to account for mutual fund heterogeneity, mutual fund ownership concentration and the position of mutual funds relative to that of major shareholders. First of all, I will include total equity ownership of all mutual fund owners among the ten largest shareholders in a company. I will also include a separate measure of equity ownership by foreign mutual funds. I will further include the number of mutual funds among the ten largest shareholders as a measure of their collective position relative to that of other investors. Again I will include the number of foreign
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mutual funds again in a separate measure. Lastly, I will measure how concentrated mutual fund ownership is by adding a Herfindahl index of the percentage of shares owned by the three largest mutual funds. Unfortunately I am unable to account for differences in the investment strategies and the size of mutual funds as information on this was not available in English for all mutual funds.
4.2.3 Control variables
In order to construct a model to estimate the impact of mutual funds I have reviewed the literature on corporate governance determinants. My main sources were two similar studies conducted by Barucci & Falini (2005) and Di Miceli da Silveira, Pereira Camara Leal, Ayres Barreira de Campos Barros & Luiz Carvalhal-da-Silva (2007). In addition to that I reviewed the Chinese literature which resulted in additional control variables relevant in the Chinese context, namely state ownership and non-freely tradable shares.
State ownership. The state remains a major shareholder in Chinese firms. The state potentially influences corporate governance in two ways. First of all, most authors argue state ownership has a negative influence on corporate governance. Chen (2001) suggests state ownership has a negative impact on Tobin’s Q. Chen & Al-Najjar (2012) find that state ownership has a negative influence on board independence. Lin (2004) suggests the state is passive and does not actively monitor firms. On the other hand, Chen et al. (2009) find that State-Owned Enterprises (SOEs) affiliated with the central government outperform private enterprises along several measures such as Tobin’s Q, but that those associated with state-owned asset management bureaus and local governments do not. Chen et al. (2009) suggest this means that ownership by the central government exerts a positive influence on corporate governance.
Xia & Zhu (2009) show that SOEs are more conservative in their accounting, which is associated with good corporate governance (Lara, Osma & Penalva, 2009). Ownership by the Chinese state is thus likely to influence corporate governance, but whether the influence is positive or negative in the case of the board is difficult to predict. I will measure state ownership as the proportion of a firm’s shares that are either directly or indirectly controlled by the state.
Foreign ownership. There are three ways in which foreign owners are likely to influence corporate governance in Chinese firms. First of all, foreign owners of shares in Chinese firms are
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often sophisticated professional investors. Secondly, as foreigners they will have an additional interest in good monitoring, because they are more distant from management. Lastly, foreign ownership can transmit good governance practices (Hasan & Xie, 2013). I will measure foreign ownership as the proportion of shares owned by foreign shareholders.
Ownership concentration. The degree of ownership concentration can influence corporate governance in two directions. First of all, large holdings are often illiquid, which means a large shareholder has a long-term stake in a firm, giving him or her incentives to push for good corporate governance (Maug, 1998). The literature studying the link between ownership and performance in China has found a positive correlation between ownership concentration and performance, which is interpreted as ownership concentration having a positive effect on corporate governance (Chen, 2001; Xu & Wang, 1999). On the other hand, large shareholders may use their large holdings to gain rents at the expense of other shareholders, which is easier when corporate governance structures are weak (Clarke, 2006). I will measure ownership concentration as a Herfindahl index of the proportion of shares owned by the three largest shareholders. As the HKSCC is registered as a single shareholder, ownership concentration will be overstated, even though HKSCC ownership will see more coordinated action as the HKSCC controls an information channel to its investors and it controls the shares of passive investors.
Non-freely tradable shares. Even though the system of non-freely tradable shares has been reformed in the period from 2005 to 2006, non-freely tradable shares remain a major feature of shareholding in Chinese firms. As part of a share’s value lies in its liquidity, owners of non-freely tradable shares will not perceive the value of their shares the same as other shareholders. They may thus pursue other goals than value-maximization. On the other hand, owners of non-freely tradable shares are highly exposed to the risk of a single firm as they lack the option to sell their shares and thus have additional incentives to ensure good monitoring.
This is similar to the argument for large shareholders made by Maug (1998). I will measure non- freely tradable shares as the proportion of shares which is not freely tradable.
Foreign listing. When a firm chooses to list its stock on a foreign market it is often motivated by access to (cheap) capital in developed financial markets. Given that Chinese Yuan are not freely exchangeable, Chinese firms could further be motivated by access to foreign currency. A developed capital market will likely have higher standards for corporate governance,
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and foreign exchanges are likely to have stricter requirements. A foreign listing has been shown to positively affect corporate governance in Chinese firms (Cheung, Jiang, Limpaphayom & Lu, 2008; Chi & Zhang, 2010). I will measure a foreign listing with a dummy variable, and this measure will include listings in Hong Kong.
Size. In the literature, size is noted as an important determinant of corporate governance quality (Barruci & Falini, 2005; Di Miceli da Silveira et al., 2009; Klapper & Love, 2002). There are three reasons for this. First of all, larger firms have more means to implement costlier governance structures. Second, larger firms often require better governance structures due to their size and the associated complexity. Third, larger size brings increased visibility and thus vulnerability to reputation damage which provide additional incentives to have good corporate governance structures. I will measure size as the natural logarithm of a firm’s revenue.
Leverage. Firms that need large amounts of capital will be subject to frequent evaluation by the providers of capital. Next to shareholders, lenders will thus also evaluate a firm’s corporate governance structures, and this may influence a firm’s cost of capital. A firm with large external financing needs is therefore more likely to have good corporate governance.
Industry. Industry is an important determinant of the differences between boards in companies (Barucci & Falini, 2005; Di Miceli da Silveira et al., 2009; Ning, Durnev & Kim, 2005; Ning, Davidson, Wallace & Zhong, 2007). This is because companies in different industries differ in how difficult they are to monitor as they face different sets of regulations and different sets of problems. I will include industry dummies at a high aggregate level using the UN Standard Industrial Classification scheme, revision 4.
Performance. Firms that are highly valued by investors are more likely to have good corporate governance. Highly successful firms may also be willing to adopt more effective corporate governance structures (Di Miceli da Silveira et al., 2009) as more scrutiny is then less of a threat to management. Performance measures suffer from simultaneity in my model as it is often argued that good corporate governance also improves performance. In a similar study on the determinants of board size and independence in Chinese listed firsms, Chen & Al-Najjar (2012) find that accounting for simultaneity by including lags does not significantly alter their results. This takes away some of my concerns, but I am unfortunately unable to account for
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simultaneity because the data available to me does not allow this. As measures of performance will cause my models to suffer multicollinearity I will only include one measure of performance, namely the price-book-value ratio for the A-shares.
4.3 Method
In order to analyze my data I have chosen to use generalized least squares regression with random effects. I have chosen to use the random effects model because I expect variation in my measures of corporate governance with respect to the board to vary in a more random rather than a fixed manner across Chinese companies. My reasoning in this is that Chinese companies face a rapidly changing economic environment as well as changing capital markets and a changing regulatory environment. These are all factors that I believe can influence the corporate governance of Chinese companies. As my observations for each company are three years apart I expect this variation to be closer to random than fixed. In addition to that, several of my variables such as industry are highly time invariant which would cause their impact to load on the intercept in a fixed effects model. I will test for the presence of random effects using the Breusch-Pagan Lagrange-Multiplier test and test the consistency and efficiency of the random effects model using the Hausman test.
I expect several groups of my independent variables to be highly correlated. An example of such a group are the measures relating to the presence of mutual funds. I also expect my corporate governance measures are correlated, as good governance along one dimension is likely associated with good governance along another. In order to deal with these correlations I will conduct factor analysis to identify underlying factors, which I will use to replace these groups of variables.
In studies on corporate governance authors often use corporate governance indices which combine a set of corporate governance measures into a single number. I have chosen to use a different approach as I feel the use of a corporate governance index requires me to make several assumptions which I feel have little theoretical basis. Bhagat, Bolton & Romano (2008) criticize corporate governance indices on three points. First they note that a corporate governance index requires a researcher to make assumptions about which aspects of corporate governance are important enough to be included. Second, they note that the use of an index also requires
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researchers to make assumptions with respect to the relative importance of individual aspects.
Third, they point out that the use of a fixed index across companies means one assumes all aspects of corporate governance included in the index are equally relevant in all cases. Though I believe the first point of criticism can be addressed by a solid application of theory, points two and three have made me decide against the use of an index.
Having chosen not to use an index I decided to use another approach which is similar to the approach used by Barucci & Falini (2005). I have created a model to predict corporate governance quality which includes my independent and control variables. Then, instead of combining all the characteristics of the board listed in into a single dependent variable, as is done in an index, I will run a regression for each characteristic separately, but before I do so I will run a factor analysis for the dependent and independent variables to identify variables which proxy for the same underlying factors and replace them with these factors in the regression. Each regression will use the same set independent variables. This approach has two important advantages. First of all, it will show what board characteristics are influenced by which determinants. Second, it will show which board characteristics are influenced by mutual funds.
Mutual funds may for example care about the number of independent directors, but not about board size. Such information yields additional insights, which would be missed when using an index.
4.4 Model specification
The model I will use in my analysis is specified as follows:
Board governance characteristic = ̅̅̅ + Mutual fund ownership + Foreign mutual fund ownership + Number of mutual funds + Number of foreign mutual funds + Mutual fund CR3 + State ownership + Foreign ownership + Ownership concentration CR3 + Non-freely tradable shares + Foreign listing + Size + Leverage + Industry + Price-to-book value ratio +
Where board governance characteristic refers to the measures for the six board governance characteristics listed in section 4.2.1.
22 5. Results
5.1 Descriptive statistics and the correlation table
Table 1 shows the descriptive statistics for the 171 observations for the 81 firms in my sample.
The table shows that mutual funds own only a small part of equity in Chinese firms. In addition to that it can be seen that a high ownership concentration, state ownership, and non-freely tradable shares are major features of Chinese shareholding, as indicated in section 2.
Table 1: Descriptive statistics
Mean
Standard
deviation Minimum Maximum Median Kurtosis
Board size 10.8655 3.3254 6.0000 19.0000 9.0000 2.5731
Independent directors 0.3726 0.0612 0.1667 0.5714 0.3571 5.2688 Executive directors 0.2193 0.1396 0.0000 0.6667 0.2222 4.1738 Shareholding directors 0.1068 0.1514 0.0000 0.6667 0.0000 4.5842 Log (Shares held by directors) 5.3076 6.1229 0.0000 18.7228 0.0000 1.5136
Board meetings 9.8129 8.0000 1.0000 62.0000 8.0000 33.2073
Mutual fund ownership 0.0202 0.0310 0.0000 0.1965 0.0059 11.1925 Foreign mutual fund ownership 0.0049 0.0144 0.0000 0.0898 0.0000 18.9513 Number of mutual funds 2.3626 2.4681 0.0000 9.0000 2.0000 2.4079 Number of foreign mutual funds 0.4035 0.9492 0.0000 5.0000 0.0000 11.6316
Mutual fund CR3 0.0151 0.0204 0.0000 0.0842 0.0055 4.2774
State-owned 0.3767 0.2538 0.0000 0.9591 0.3808 2.0340
Foreign-owned 0.1616 0.1354 0.0000 0.7995 0.1557 4.8832
Total CR3 0.5658 0.2346 0.1003 0.9804 0.5596 1.8376
Non-freely tradable shares 0.2134 0.2490 0.0000 0.8755 0.0878 2.4629
Log (Revenue) 9.4275 2.3651 2.4069 14.8400 9.7391 2.9556
Leverage 3.6829 5.9432 0.1259 35.2833 1.3276 9.6154
Price-book-value ratio 3.5146 3.2225 0.6000 23.9000 2.5000 14.3169
Table 2 on page 24 shows the correlations between the independent variables. There are two groups of variables which show highly significant correlations with each other. The first of these groups is composed of the variables relating to the presence of mutual funds. The second group of variables that correlate is revenue, state ownership, non-freely tradable shares and ownership concentration CR3. These variables correlate because the Chinese state often owns a large amount of non-tradable shares in large companies. The correlations in these two groups suggest they each vary based on an underlying factor.
23 5.2 Factor analysis
In order to detect underlying factors in my variables I have conducted principal factor analysis followed by varimax rotation for both my dependent and independent variables. I then selected factors to include in my analysis based on the Kaiser criterion of minimum eigenvalues of 1.00.
The reason for conducting factor analysis for the dependent factors is that it is likely measures of governance are driven by the same underlying factors.
Table 3 shown below shows the result of the factor analysis for my six dependent variables.
Based on Hair et al. (1998) I have decided to use the cutoff point of 0.45 for non-trivial factor loadings based on my sample size of 171 observations. Factors that exceed this cut-off point are shown in bold. The high loadings of shareholding directors and shares held by directors are not surprising as more shareholding directors are likely to own more shares. As the values for the proportion of shareholding directors and the number of shares owned by directors are driven by the same factor, I will replace these two variables with factor 1 which thus reflects director shareholding.
Table 3: Dependent variable factor analysis
Factor 1
Board size 0.03584
Independent directors -0.03122
Executive directors -0.03938
Shareholding directors 0.45889 Shares held by directors 0.48055
Board meetings -0.02368
