Master Thesis for International Business and Management
The Impact of Interlocking Directorates on Firm Performance:
Evidence from China
By Wenchao Ren
Supervisor: Dr. Kees van Veen
University of Groningen Faculty of Economics and Business
Abstract
This study examines the impact of interlocking directorates on performance of Chinese listed firms, including the impact of intra-industry interlocks, inter-industry interlocks, and banking interlocks, and moderated by the ownership structure. Hypotheses are given based on the resource dependency theory, and related to the current situation of Chinese corporate governance. The analysis of 283 Chinese listed firms demonstrates that there is no significant correlation between interlocks and firm performance, and the relationship between interlocks and firm performance is not related to the ownership structure.
Key words: interlocking directorates, firm performance, resource dependency, ownership
structure, China
Research theme: interlocking directorates Supervisor: Dr. Kees van Veen
Contents
1. INTRODUCTION ... 5
2. LITERATURE REVIEW ... 9
INTERLOCKING DIRECTORATES AND FIRM PERFORMANCE ... 9
CORPORATE GOVERNANCE OF CHINESE LISTED FIRMS ... 11
Highly concentrated and state-owned ownership structure ... 13
Excessive power of the proprietary shareholder and actual controller ... 15
Lack of board independence ... 16
THE IMPACT OF INTERLOCKING DIRECTORATES ON PERFORMANCE OF CHINESE LISTED FIRMS ... 17
The impact of interlocking directorates on performance of state-owned listed firms ... 19
The impact of interlocking directorates on performance of private listed firms ... 21
INDUSTRY INTERLOCKS AND FIRM PERFORMANCE ... 22
DEVELOPMENT OF CHINESE INDUSTRIES DURING ECONOMIC REFORM AND INSTITUTIONAL TRANSITION ... 23
THE IMPACT OF INDUSTRY INTERLOCKS ON PERFORMANCE OF CHINESE LISTED FIRMS ... 25
The impact of industry interlocks on performance of state-owned and private listed firms ... 26
BANKING INTERLOCKS AND FIRM PERFORMANCE ... 27
BANKING REFORM IN CHINA ... 28
THE IMPACT OF BANKING INTERLOCKS ON PERFORMANCE OF CHINESE LISTED FIRMS ... 29
The impact of banking interlocks on performance of state-owned and private listed firms ... 30
3. METHODOLOGY ... 32
DATA ... 33 VARIABLES ... 33 Dependent variables ... 33 Moderating variables ... 34 Independent variables ... 34 Control variables ... 35 TEST ... 36 4. RESULTS ... 37
5. CONCLUSION AND DISCUSSION ... 40
LIMITATION AND INDICATION ... 42
1. Introduction
The situation that a single person serves on two or more boards of firms at the same time is called an interlocking directorate.1 Research on interlocking directorates can be date back to the beginning of the 20th century. Mizruchi (1996) presented a comprehensive analysis studying both the forming and consequences of interlocking directorates. There are also many researches analyzing the impact of interlocking directorates on firm performance. The board functions to link an organization to external environment to gain resource, monitor internal governance, and make strategic decisions (Shen & Long, 2011). Interlocking directorates are expected to make the board function more effectively to help the firm achieve better performance, because they help to build connections with other organizations to get access to more resources and information (Ong, Wan, & Ong, 2003), and improve the appropriateness and feasibility of strategies carried out by the board (Liu, 2009).
Nowadays, interlocking directorates are very common in China. As the largest emerging country, China has a unique, socialist and market-oriented economy, and is experiencing an economic and institutional reform (Yang, Chi, & Young, 2011). After the financial crisis, which took place in 2008, corporate governance in western world became the target of public criticism, and has attracted considerable attention. This can definitely bring lessons to China whose corporate governance requires development during the economic reform and institutional transition.
Therefore, the main research question is “What’s the relationship between interlocking
directorates and firm performance of Chinese listed firms?”
Different from Western firms, whose main agency conflict is between shareholders and managers, the main agency conflict in Chinese firms is between proprietary shareholders and minority shareholders, owing to the highly concentrated ownership structure (Hu, Tam, & Tan, 2009). The conflict between shareholders and managers can be relieved through appropriate mechanisms, such as formal regulation, markets for corporate control, and managerial interest alignment contracts in Anglo-American corporate governance model (Hu et al., 2009). However, in China, the legal protection for shareholders is weak, and the external governance mechanism, such as competitive market for corporate control and CEOs, is inefficient. Therefore, in China, internal governance mechanisms, including ownership structure, board of directors, and supervisory board, play a more prevalent role. As one of the major internal governance mechanisms, board of directors has attracted more and more attention.
There is no lack of research on boards of Chinese firms, especially during resent years (Fu, 2008; Gong & Yan, 2009; Sui, 2009; Liu, 2009; Yu, 2011). Those researches largely study the independent directors, focusing on their monitoring function and independence issues. Studies on interlocking directorates are relatively fewer. In fact, interlocking directorates can also be a good mechanism to manage the board behavior. However, researches analyzing interlocks in China are more from a network perspective that focuses on the business network structure in Chinese market (Ren & Au, 2004; Ren, Au, & Birtch, 2009), overpassing the impact of interlocks on management and firm performance.
Shareholders acquire control rights through holding large amount of firm shares. Indeed, highly concentrated ownership is a vital feature of Chinese firms. For firms with concentrated ownership structures, the actual controllers and the proprietary shareholders are dominators. Whereas those firms could be state-owned, or private owned. State-owned firms and private firms have different management goals, enjoy different policy treatment, and have actual controllers with different nature. Therefore, the boards of state-owned firms and private firms may function differently, and the interlocking directorates may play different roles. Within this context, what impacts the interlocking directorates can bring to the firms, and whether such impacts are different in state-owned firms and private firms, are worth studying, especially when China is in a reform and transition period.
During the past three decades, the corporate governance structure, industrial structure, and financial system in China have experienced dramatic changes owing to the economic reform. Interlocks between firms in various industries, and between firms and banks also change along with the economic reform. Given the low level of corporate governance structure and the special historical period of China, a study of interlocking directorates can not only find the impact of various interlocks on firm performance, but also reveal flaws of corporate governance in Chinese firms, features of interlocks in various industries, and shed light on the future direction of institutional transition.
2. Literature Review
Interlocking directorates and firm performance
Interlocking directorates occur when a single person sits on more than one governing bodies. Interlocks are automatically formed between those governing bodies, they can be formed just by chance during the appointment of directors, or on purpose as a result of conscious decisions by top management of the firms (Mizruchi, 1996). According to Hung (2003) and consistent with resource dependence theory, the major function of directors is to control, obtain, and exchange resources and information. Interlocking directorates can be used as indicators of corporate control, inter-organizational resource dependency, and can bring economic benefits to the firms. Researches on Singapore companies have found that there is a positive and significant relationship between interlocking directorates and firm performance (Phan, Lee, & Lau, 2003; Ong et al., 2003). And Silva, Majluf, & Paredes (2006) also found evidence supporting a positive relationship between interlocks and firm performance.
There are two types of interlocking directorates. Concomitant interlocking directorate, which means, a single person serves two or more boards at the same time, whereas serial interlocking directorate means that a single person rotates membership on different governing bodies at different times, especially between political offices and corporate boards (Kentor & Jang, 2004). In this study, only the first type of interlocking directorates, namely the concomitant interlocks will be mainly analyzed.
Cooptation is consistent with resource dependence theory. It supports that interlocks are associated with inter-organizational resource dependence. According to resource dependence theory, the resources an organization depends on are often in hand of other organizations.2 Board of directors can be viewed as important boundary spanners who build the connections with environment and resources, and firms may use interlocking directorates to achieve better communication with other organizations (Au, Peng, & Wang, 2000). They can help to establish inter-organizational coordination, which makes the firms unite to compete with other firms and gain more profits (Ong et al., 2003). Firms can use interlocking directorates as a way to build connection with other organizations to not only acquire resources, but also share and exchange resources, information, and knowledge to gain higher profits that they cannot achieve solely (Liu, 2009). Interlocking directorates can facilitate the communication among different firms and provide more information to interlocking firms (Mizruchi, 1996). More communication and information can reduce the environmental uncertainty a firm faces, helping a firm to better acquire and allocate its resources to react to changes in the market fast and efficient (Phan et al, 2003). Interlocking directorates can also improve the appropriateness and feasibility of strategies carried out by the board, thereby enhance the strategic function of the board (Liu, 2009).
Another role that interlocking directorates may play is monitoring. Firms may employ board seats as devices to monitor other companies (Mizruchi, 1996), especially between holding companies and affiliates, and between banks and their debt firms.
The quest for legitimacy can also be a reason to have interlocking directorates. The prestige of a director may have impact on the reputation of the firm. Investors may prefer corporations
with good reputations and high-quality management resources (Liu, 2009). Having interlocks with other firms can be a signal to potential investors that this is a legitimate firm worthy of investment (Mizruchi, 1996). In addition, interlocks can provide reliable source of directors. Interlocks are created by individuals. An individual may join the boards for various reasons, such as financial remuneration, prestige, and useful contacts (Mizruchi, 1996). Shareholders want them to add prestige, provide useful strategies to achieve better firm performance; therefore they want to find the right persons. The connections with other boards can be a good way, because the interlocking directorates not only develop a managerial network for firms, but also create a network of management elites. It’s said that boards sometimes recruit new directors through interlocks and other social ties, such as friends or acquaintances that are already on the board, because personal contact can provide more information that is not available in other ways such as resumes (Davis, 1996).
In summary, interlocking directorates can provide easier access to resources and information (Ong et al., 2003), help to monitor the board behavior, and may also add prestige to the firm (Mizruchi, 1996). Appropriate recruitment of interlocking directorates may enhance the strength of the board and the firm, lower environmental uncertainty, improve organizational and financial performance and help the firm to survive and develop in competitive markets (Hung, 2003).
Hypothesis 1: Interlocking directorates are related to firm performance.
Corporate governance of Chinese listed firms
structure reform has been a vital part of the economic reform all along. At the beginning of the reform, the major object was the public sector in the economy. Before the reform, the government controlled domestic economy, the production and management of goods belonged to the state. In 1981, it was proposed that the state-run economy and collective economy was China's basic economic form, individual economy in a certain range could be a necessary complement of the public sector in the economy. In 1982, it was raised that socialist state economy was in a dominant position of Chinese economy, and a variety of economic forms would have to coexist in a long time. With the goal of transforming into market-oriented economy, corporatization was carried out. Since then, the pace of economic development has been increasingly rapid. Then in 1987, for the first time, private economy was brought forward as a supplement of Socialist economy. During this period, individual and private economy achieved recovery and development, foreign investment also increased. (Zou, 2008)
limited liability companies through restructuring and reorganization, and state ownership in firms decreased. And Chinese enterprises started to invest overseas.3
After 2002, the transformation of state-owned enterprises was further enhanced, and the proportion of non-state-owned economy increased a lot. The collective economic restructuring has basically completed. The individual, private and other form of non-public economy were further developed. Private enterprises were encouraged to engage in foreign trade. And foreign investments were allowed to enter commercial banks in China. With the increase of foreign investors, the corporate governance frame in China was forced to develop, to converge with international standard (Cheung, Jiang, Limpaphyom, & Lu, 2010). In 2006, China revised its company and securities law status, which indicated further development of corporate governance frame. Although it’s said that the corporate governance of Chinese firms is approaching Anglo-American standard (Howson & Khanna, 2010), the corporate governance in China still requires improvement.
There are several features, or in fact, drawbacks of corporate governance of present Chinese listed firms: (1) highly concentrated and state-owned ownership structure; (2) excessive power of proprietary shareholder and actual controller; (3) lack of board independence.
Highly concentrated and state-owned ownership structure
The ownership structures of a large proportion of Chinese listed companies are highly concentrated and state-owned. Although the ownership structure of Chinese firms has transformed dramatically, it’s still quite different from that in developed countries (Silva, et.
al, 2006). The state still holds large ownership of many enterprises through state shares4 and state-owned legal person shares5, and those state-owned enterprises account for a large proportion of Chinese firms.
Companies that hold shares of the state can be divided into three categories, wholly state-owned companies, state-holding companies, and state joint-stock companies. Wholly state-owned companies are, obviously, wholly owned by the government, targeting to pursue social and public goals as priority rather than economic benefits, and are mainly concentrated in public service and resource industries, such as railway and petroleum industry. State-holding companies are not wholly owned by the government, but controlled by the government through state shares or state-owned legal person shares. Those companies pursue both social and economic goals, and are concentrated in mainstay industries, such as automotive and pharmaceutical industry. State joint-stock companies are, in fact, not state-owned enterprises, but normal private companies with the main goal of economic benefits. The government is just an ordinary equity participant in those companies, aiming to strengthen the power of the state-owned economy, and has no other additional intervention on the operations of these companies.6
Chinese listed companies are mainly comprised of state-holding companies, which are state-owned, and private companies (including state joint-stock companies). State-owned companies are governed by both local governments and, in the central government, the
4 State shares are formed by the state-owned assets investments of the departments or institutions represent the state,
including the state-owned shares converted from existing assets.
5 State-owned legal person shares are obtained through legal procedures when state-owned enterprises, institutions, and
other sectors that have legal personality invest their legally occupied corporate assets to a company that is independent of them.
SASAC7,8 and would receive government intervention (Yu, 2011). In countries with advanced corporate governance frame, the level of legal protection of private investors is higher, and firm information is more transparent. Expropriation of shareholder interests by top management tends to be easier to get caught and punished. But in China where the legalization level is relatively low, it requires higher capital input from the shareholders to monitor the management of the firm and exercise their rights. Therefore, concentrated ownership became a substitution of legal protection for shareholders to gain dominance over the board (Gong & Yan, 2009). However, for state-owned firms, higher state ownership indicates higher government intervention, because the behavior of a firm is controlled by its proprietary shareholder and actual controller.
Excessive power of the proprietary shareholder and actual controller
According to the Company Law of People’s Republic of China, “a proprietary shareholder
means a shareholder whose capital contribution accounts for more than 50 percent of the total capital of a company with limited liability or the amount of the shares who holds accounts for more than 50 percent of the total amount of the shares of a company limited by shares; and a shareholder, although the amount of his capital contribution or the proportion of the shares he holds is less than 50 percent, whose voting rights enjoyed on the basis of the amount of capital contribution made or the number of shares held are enough to have a vital bearing on the resolutions of a shareholders’ meeting or a shareholders general assembly”.9
And “an actual controller means a person who is able practically to govern the behavior of a company through investment relations, agreements or other arrangements, although the
7 http://en.wikipedia.org/wiki/SASAC
8 http://en.wikipedia.org/wiki/Government-‐owned_corporation#China.2C_People.27s_Republic_of
person is not a shareholder of the company”.10 All in all, the actual controller of a firm is natural person, legal person or other organization that actually controls the firm.
For private listed companies, the actual controller is usually the same with its proprietary shareholder, whereas for most state-owned listed companies, the actual controller is SASAC, except that some state-owned listed companies are directly controlled by local governments. There are also some private listed firms, whose ownership structure is quite dispersed, having no proprietary shareholder or actual controller, but such firms only account for a very small part of big Chinese listed firms.
In China, shareholders’ meeting follows the “one share one vote” rule, which empowers the proprietary shareholder to dominate the behavior of the firm and the decision-making of the shareholders’ meeting, including the appointment of directors and supervisors. The power of the board is concentrated in the hands of the chairman and executive directors, who are usually the representatives of the proprietary shareholder (Hu et al., 2009; Shen & Long, 2011; Yang, Cheng & Liu, 2005). Meanwhile, the proprietary shareholder usually follows the decisions made by its actual controller, which means that, in fact, the dominator of a firm is its ultimate actual controller.
Lack of board independence
Board of directors is always a very important part of corporate governance. For Chinese listed firms, the board is usually composed of executive directors, independent directors, and supervisors. According to the Company Law11, the shareholders’ meeting elects both
directors and supervisors, and a resolution to be made by the shareholders’ meeting shall be subject to adoption by more than half of the voting rights held by the shareholders present at the meeting. Therefore, basically, those directors and supervisors are appointed and nominated by the proprietary shareholder. This gives incentive to the directors to make decisions in favor of the proprietary shareholder, as well as the actual controller. In such circumstance, independent directors and supervisors cannot execute their duties effectively (Yang et al, 2005). Besides, the proportion of independent directors on board is relatively small, which basically accounts for around one third of the board size. Independent directors cannot have a significant impact on board, and this may reduce their enthusiasm for decision-making, thus influence the effectiveness of their monitoring and controlling functions (Yang et al, 2005; Liu, 2009; Sui, 2009).
All these may influence the role that interlocking directorates play on board and their impact on firm performance.
The impact of interlocking directorates on performance of Chinese listed firms
There is a saying that, “In the West, relationships grow out of deals. In China, deals grow out
of relationships” (Vanhonacker, 2004). Different from western market system which
market demand the businessmen for more “insider” information of the society (Vanhonacker, 2004). Embedded in networks, firms can obtain considerable advantages, such as increase in innovation, access to new markets, sharing network resource, decrease in transaction costs and cycle times, and management of environment uncertainty (Heracleous & Murray, 2001). To build relationships with others, interlocking directorates became a common way in Chinese firms (Ren et al, 2009).
Interlocking directorates play an important role in Chinese business since long before, and the form of interlock inevitable transformed along with the economic reform. During the early stage of Chinese economic reform, although wholly state-owned economy was broke, interference of the government in business activities was still common and serious. With this background, the pervasiveness interlocks between government and corporations was regarded as one of the main features of Chinese firms (Phan et al, 2003). Later, with the decrease of government resource control, government intervention on business, regulatory policy uncertainty, and the increase of comprehensiveness and effectiveness of legal system, the dependence of corporations on government declines, the interlocks between government and corporations became weaker and weaker (Peng & Zhou, 2005). The Civil Servant Law of the People's Republic of China promulgated in 2005 explicitly stipulates that the civil servants
cannot hold concurrent positions in enterprise or other for-profit organizations. At present,
Given the features of Chinese corporate governance and the inherent problem in Chinese firms, the effect of interlocking directorates may be diverse in state-owned listed firms and private listed firms.
The impact of interlocking directorates on performance of state-owned listed firms
Chinese business system is said to consist of network capitalism that works through various relationships (Ren et al, 2009). Firms build relationships through interlocks to embed themselves in the business networks. Interlocking directorates are used to acquire information and opportunities in other businesses and industries to reduce environmental uncertainty, and to share and exchange resources with other firms to achieve better firm performance (Liu, 2009).
However, for state-owned listed firms, their main target is usually the maximization of social welfare and political achievements, instead of firm performance (Yu, 2011). In Chinese firms, the decision-making right belongs to the proprietary shareholder and the actual controller. And the appointment of directors also depends on the actual controllers. The actual controller of the state-owned listed firms, who is usually SASAC, will make decisions favorable to the state, rather than the other shareholders. And the directors appointed by the SASAC will have incentive to support the decisions of the proprietary shareholder and the actual controller. The duty of SASAC is to manage and monitor state-owned assets, and to promote the strategic adjustment of the structure and layout of the state-owned economy. Therefore, state-owned firms will probably receive higher state intervention. Such intervention sometimes is given from a macro economic market perspective, rather than firm performance oriented.
the national economy by the government. During this process, the state will play a regulatory role in keeping an effectively functioning market economy through economic policies, regulations, planning and necessary administration.12 State-owned enterprises play a vital role in macro-control. As mentioned earlier, the behavior of state-owned firms will pursue social and public interests, rather than business interests. This is caused by their ownership structure that connect firms tightly with the state. The government proceeds and promotes macro-control through enhancing the control over state-owned economy, using state-owned enterprises as a tool (Zhou & Tan, 2001). Therefore, the state-owned firms usually influences by macro-control policies from an overall market stability perspective, whereas private firms are influenced by free market competitions.
In the appointment of board of directors, SASAC will focus more on the interests of the state, rather than minority shareholders, and their strong influence on board will weaken the governance role of other directors (Hu et al., 2009). In addition, the state-owned listed firms will take more conditions into consideration apart from firm performance enhancement. In principle, state-owned enterprises belong to all the people, the government or SASAC are proxies to manage those assets, and the directors are proxies of the government and SASAC. The chairmen who represent the actual controller are empowered to executive part of the rights of the board, resulting in them have excessive power on boards. The other directors can’t have effective impact on board. The overall decision-making mechanism cannot work effectively and results in the autocratic of the chairmen (Yang et al., 2005). They don’t own the profits or bare the losses of the firms, whereas they have high control rights. Therefore, they have incentive to pursue self-benefits on the cost of state-owned assets and other shareholders. To prevent such situation, state-owned listed firms usually have more directors
that have government background, to better monitor the utility of state-owned assets (Yu, 2011). But this will lead to higher interference of the state.
In a word, the appointment of interlocking directors in state-owned listed firms is usually to enhance the management of state-owned assets, rather than financial performance. And because those interlocking directors have incentive to make decisions on favorable to the proprietary shareholder and actual controller, they cannot well perform their monitoring role.
The impact of interlocking directorates on performance of private listed firms
As mentioned earlier, interlocking directorates are supposed to be a way to build connections with other firms to acquire and exchange resource and information to reduce environment uncertainty and achieve better firm performance (Hung, 2003; Au, Peng, & Wang, 2000; Liu, 2009; Mizruchi, 1996; Ong et al, 2003).
Hypothesis 2: Interlocking directorates have higher positive impact on performance of
private listed firms than state-owned listed firms.
Industry interlocks and firm performance
The economic reform reflects various aspects of Chinese economy, including the industrial structure. It’s illustrated earlier that a very important reason for Chinese firms to have interlocks is to develop networks (Ren et al, 2009; Vanhonacker, 2004). Different firms have different dependence of industrial resources and expertise, and various industrial attributes may bring various influences on the connection between firms and their performance by influencing the strategies employed by directors that are interlocked in the network (Luo, 2003). The macro environment of the market can influence the industry structure, and the industrial uncertainty will have impact on the executives’ decision-making. Industrial growth and changes in industrial regulations can force firms to improve connections with others. In addition, competitive pressure can also influence firm strategies. Then those industrial factors, which are industrial uncertainty, industrial growth, regulation, and competitive pressure, can influence the interlocking network (Luo, 2003). Especially in China that is experiencing an economic reform as well as an institutional transition.
Development of Chinese industries during economic reform and institutional transition
Since the economic reform, forced by the regional policies of the state, the industries in China have gone through huge changes, including the distribution and competitiveness. At the beginning of the reform, the eastern coastal regions first started to industrialize and developed fast. Cities across this area were committed to industrial development, and compete for resources and capitals. Driven by the optimal allocation of resources, the competition between various provinces and cities tended to be moderate and transformed into cooperation, competitions are scattered and in small scales. Hereafter, more eastern areas opened up as “Economic open zones”, industrial competition was not limited in provinces or cities, but concentrated with the three economic circles as main competition body.13 After the year 1992, the development of the three economic circles enhanced dramatically. As the earliest economic development area, Eastern China has been the center of High-tech industries and manufacture industries.
After entering the new century, the gap of industrial development between Eastern China and Western China kept increasing. In order to reduce the regional disparities and promote coordinated regional development, the “Western development strategy” was issued by the state. To this end, several large projects were carried out in Western China. Large-scale construction of airports, railways, and high ways was started in western areas. Industries in the west developed rapidly. Although still not as competitive as east region, west region has gradually become one of the main industrial areas in China. This changed the original industrial pattern in China that competition of industries concentrated in Eastern China. Taking advantages of rich resources, relatively low-cost factors of production, and
13 Three economic circles are the Tangtze River Delta, Pearl River Delta, and Bohai Economic Rim, they are all in Eastern
preferential state policies, Western China has become increasingly attractive to investments and it also gathered many energy industries. This brought strong pressures and challenges to Eastern China industry area.
Following the “Western development strategy”, northeast area began to draw the attention of the state. There are profuse natural resources and certain industrial basis in Northeast China, but the industrial development of this area was seriously lagging behind Eastern China during the economic reform. In 2002, the state put forward to accelerate the adjustment and transformation of northeast industrial area. Consequently, Northeast China industrial development became the next key reform area after Western China. By virtue of original industry basis, adding new systems and mechanisms, the competitiveness of Northeast China industries improved significantly. Although it’s still in an inferior position compared with other areas that developed much earlier, Northeast industry area has become one of the most important heavy industry bases in China.
As a result of the fast development of the three areas mentioned above, problems stand out that the development of Central China regions has fallen behind. The acceleration of industrialization in Central China started in 2005, when the state proposed to formulate plans and measures to promote the development of industries in Central China. So far, Central China industrial area has become one of the main bodies in Chinese regional industrial competition, and at the same time, played an important role in linking the other three industrial areas. In the next few years, the Chinese regional industrial competition will be still among those four main areas, which are Eastern, Western, Northeastern, and Central China.14
Along with the economic reform and institutional transition, industries in China are increasingly concentrated geographically, and the state policy varies in connections with different industries.
The impact of industry interlocks on performance of Chinese listed firms
With the increasing attention paid on the research on interlocking directorates, various interlocks are distinguished and the influence of them is also examined separately. Relationship with other firms can be utilized to enhance a firm’s market power and the ability of resource allocation, and industry context will have an impact on this (Goes & Park, 1997). In China, the geographically concentrated industrial distribution facilitates the forming of intra-industry interlocks. Although intra-industry interlocks has been prohibited in many developed countries because of a collusion problem, firms in China can form interlocks both in the same industry or different industries. Interlocking networks within an industry help to generate profit differentials for the interlocked firms and help to share resources with connected firms. With interlocking directorates, firms can gain privileged access to network resources that confer cost and value based advantages (Heracleous & Murray, 2001). Because firms in the same industry will also seek for different resources and benefits, different strategic choices are made and lead to changes in intra-industry interlocking networks (Peng & Zhou, 2005). And the development of interlocking network will bring more advantages to its members.
economic development of China. Industrial uncertainties that result from the changing industrial structure impel firms to develop relations with firms not only in the same industry, but also in other industries to gain resources, information, and new opportunities (Luo, 2003). Firms interlock with powerful buyers and suppliers can manage its resource interdependencies effectively (Davis, 1996). Interlocking directorates from a wide range of industries can help firms to gain more valuable information and opportunities (Mizruchi, 1996). When the labor market for directors and senior managers in an industry is relatively small, intra-industry interlocking directorates may exist, and those individuals are likely to be familiar with each other (Jensen, 1993). Whereas interlocks with inter-industry firms can bring access to more diverse resources that confer the firm greater absorptive capacity to address a broader set of competitive challenges (Phan et al, 2003). And it’s found that intra-industry interlocks benefit the individual directors more, rather than the firm, on the contrary, inter-industry interlocking directorates have significant positive impact on firm performance, because they allow the top management to scan widely to perceive threats and opportunities from a broader environment (Phan et al, 2003).
Hypothesis 3a: Intra-industry interlocks have positive impact on firm performance. Hypothesis 3b: Inter-industry interlocks have positive impact on firm performance.
Hypothesis 3c: Inter-industry interlocks have higher positive impact on firm performance
than intra-industry interlocks.
The impact of industry interlocks on performance of state-owned and private listed firms
and development of other industries (Lu, 2008). For some other industries, although the wholly state-owned enterprises keep carrying on restructuring, the state-owned enterprises still account for a large proportion. In these industries, the competitive pressure is low for the state-owned firms. Therefore, the state-owned firms have less incentive to develop relations with others. Besides, regulations may show partiality for state-owned firms, because they demand public interests at the first place. Owing to the support of the government, the state-owned firms can face less environmental uncertainties, thus less incentive to enhance their managerial networking.
However, for private firms that do not have the government as supporter and do not enjoy policy favoritism, they face with relatively higher competitive pressure and environmental uncertainty. Therefore, they need to develop their managerial networking, to interlock with other firms in intra or inter industries.
Hypothesis 4a: Intra-industry interlocks have higher positive impact on performance of
private listed firms than state-owned listed firms.
Hypothesis 4b: Inter-industry interlocks have higher positive impact on performance of
private listed firms than state-owned listed firms.
Banking interlocks and firm performance
building connections with banks seems still very important for firms in China. And banks and the financial market of China have also been developing during the economic reform.
Banking reform in China
Since the economic reform and the institutional transition, China has experienced huge changes, not only reflected in the development of corporate governance and industries, but also reflected in the banking system. Before 1984, the bank organizational system is highly monopolized and was under centralized control and management of the state. A reformed bank organizational system, which was under the leadership of the People’s Bank of China and with state-owned banks as the main body, was formed since 1984 (Cheng, 2001). State-owned enterprises budgetary allocations were replaced by bank credit, and banks became more profit-oriented.
In pace with the development of economic reform and the promotion of state-owned bank reform, commercial banks appeared. In the early 1990s, the state proposed to separate policy banks from commercial banks, and grated limited licenses to certain foreign banks and non-state owned commercial banks. In addition, standard accounting and prudential norm were introduced into financial systems in China (Hasan, Wachtel, & Zhou, 2009).
(Berger, Hasan, & Zhou, 2007).
The biggest turning point was in 2003 when the China Banking Regulatory Commission was formally established. It indicated that China’s banking regulation had entered a new era. Along with this, the parallel system of banking, securities, and insurance will be further improved. It also marked the end of the time that monetary policy, financial regulation, commercial bank, and other functions were all concentrated on People’s Bank of China. Since then, bank system in China has gained dramatic improvement. The codes of bank corporate governance and accounting standards were both revised according to international practice, and private ownership as well as foreign ownership in banks also increased a lot. (Berger, Hasan, & Zhou, 2007)
The impact of banking interlocks on performance of Chinese listed firms
The presence of banking interlocks can be owing to their financial dependency. In accordance with resource dependency theory, for a firm which requires financial resource support, interlocking with bank is obvious a good choice. Interlocking with banks may lower competition and raise profits (Fligstein & Brantley, 1992).
Besides, banking interlocking directorates also play a monitoring role on firm board (Mizruchi, 1996). Firms may use board seats as a device to monitor other firms, especially for large stockholders, bankers and customers (Mizruchi, 1996). For banks that hold stocks of other firms, having interlocks with them provide a convenient channel to monitor the firms’ performance. For the firms have interlocks with banks, the interlocking directors can provide professional advice on firms’ financial affairs, and can also prevent the proprietary shareholder to take excessive risks on the cost of minority shareholders. The finding that when firms suffer declining performance, bankers have higher possibility to be appointed to the board is also support the monitoring role that played by banking interlocking directorates (Richardson, 1987; Mizruchi, 1996). Therefore, in summary, it can be indicated that firms with banking interlocks tend to achieve better performance than firms without banking interlocks.
Hypothesis 5: Banking interlocks have a positive impact on firm performance.
The impact of banking interlocks on performance of state-owned and private listed firms
can get “policy lending” from largest banks that controlled by the government; second, loans to state-owned banks are safer because of the government bailout when problems occur, and this is due to the less developed legal protection of private property in China; third, the government has incentives to assist state-owned firms to create more resource and political capital for the government (Lu et al., 2012). Therefore, for state-owned firms, they can easily acquire bank support, regardless whether they have banking interlocks or not.
However, private firms tend to suffer bank discriminations due to the reasons mentioned earlier, they are expected to have higher incentives to build ties with banks. And this will lead to interlocking directorates. The monitoring role of banking interlocking directorates can also benefit the firm. Moreover, ties with banks can benefit the firms through lower financial expenses and better lending terms during difficult times, and for private firms, it can also reduce bank criminations (Lu et al., 2012). Therefore, interlocking with banks seems to be more important for private firms rather than state-owned firms.
Hypothesis 6: Banking interlocks have higher positive impact on private listed firms than
3. Methodology
To test those hypotheses raised above, a quantitative analysis will be applied.
Sample
This research studies the listed firms of China. There are several types of shares included in the shares issued the listed firms, for example, A-shares, B-shares, H-shares, N-shares, and S-shares, of which A-shares and B-shares are the main types.
The official name of A-shares is RMB common stock. It’s issued by the companies in the territory of China, is subscribed and traded in RMB only for domestic institutions, organizations, and individuals (Taiwan, Hong Kong, and Macao investors are not included). Accounted for the largest proportion in tradable shares issued by firms in Chinese stock market, A-shares developed fast during the past two decades, and A-shares market has achieved a certain scale as well. However, A-shares are not the most issued shares by firms. Most of the listed firms in China have non-tradable state shares and state-owned legal person shares etc.15
The official name of B-shares is RMB special shares. B-shares are also issued by firms registered in the territory of China and use RMB to indicate the nominal value as A-shares, but are subscribed and traded in foreign currency. And B-shares are mainly open to investors out of the mainland of China. The investors of B-shares include natural persons, legal persons and other organizations from foreign countries, Taiwan, Hong Kong, and Macao; Chinese citizens who reside aboard; and other investors regulated by China Securities Regulatory
Commission (CSRC). But in the year 2001, B-shares were open to domestic individual investors. At present, the major investors of B-share are institutional investors.16
This analysis only employs the A-shares firms of the Top500 listed Chinese firms. Because in Chinese stock market, A-shares always hold a major position, in the Top500 listed firms, most are A-shares firms, and their corporate structures and operations are more stable. Some A-shares firms that also listed in Hong Kong or foreign stock exchanges are excluded. Because firm performance may be influenced by cross listing in different stock exchanges. The legal system and information disclosure environment in Hong Kong is stricter than in the mainland of China, and this will enhance the corporate governance of the cross-listed firms. Changed corporate governance framework may have impact on firm performance (Ji & Liu, 2011; Gozzi, Levine, & Schmukler, 2008). Finally, a sample of 283 firms is selected from the Top500 listed firms in China.
Data
After the 283 sample firms are selected, their data of the year 2011 is collected. Most data is collected from the annual reports of the sample firms, such as the data of board directors and the general information of the firms. Some other information is from the website of Sina financial17, such as the industry index and listing year of the firms.
Variables
Dependent variables
The dependent variable in this analysis is firm performance. There are various methods to measure a firm’s performance, and here I mainly analyze a firm’s profitability. Therefore, as the most widely used indicator of profitability, Return on Assets (ROA) is used in this analysis. ROA is an indicator on how profitable a company is relative to its total assets. It provides an idea on how efficient management is in using assets to generate profits. But ROA can be influenced by various factors, especially industry.
Moderating variables
To test the influence of ownership structure on the impact of interlocking directorates on firm performance, the ownership structure will be used as a moderating variable.
Ownership = 1 when a firm is state-owned listed firm, which means that the actual controller of this firm is SASAC or the government.
Ownership = 2 when a firm is private listed firm, which means that the actual controller of this firm is not SASAC or the government, or this firm has no proprietary shareholder or actual controller.
Independent variables
Interlock, which is measured as the number of interlocks that a firm has with other firms. For example, A is a director of firm X, Y, and Z, then for firm X, the number of interlocks is 2, one with Y and the other with Z.
Inter-industry interlock, which is measured as the number of interlocks that a firm has with other firms in different industries.
Banking interlock, which is measured as the number of interlocks that a firm has with other firms in banking industry.
Control variables
Because firm performance can be influenced by various factors, it’s necessary to define adequate control variables to reduce the bias. In this analysis, the control variables are industry, firm size, and firm age.
Industry of a firm is defined according to its industry code on Sina financial website. ROA is supposed to be highly dependent on the industry. Therefore it has to be controlled. There are 12 industries included in this research. The industry of a firm will be translated into dummy variable for the tests.
Firm size, is measured as the firm’s total assets. ROA is calculated by dividing a company's annual earnings by its total assets, therefore, a firm’s total assets will directly influence the value of ROA.
Test
4. Results
Table 1 illustrates some basic data of interlocks in Chinese listed firms, including 196 state-owned firms and 87 private firms. Of the 283 firms that are analyzed in this research, 159 of them have interlocks. Most firms have 1 or 2 interlocking directors on board. Of the 2,726 directors from the 283 firms, 129 are interlocking directors holding 277 board seats with 334 interlocks in total. Among the 334 interlocks, 239 are held by state-owned listed firms with an average18 of 1.22, and 95 are held by private listed firms with an average of 1.09. The average of total interlocks is 1.18. And there are 158 intra-industry interlocks in total with an average of 0.56, of which the state-owned listed firms have 122 with an average of 0.62, while the private listed firms have 36 with an average of 0.41. For inter-industry interlocks, the state-owned listed firms have 117 with an average of 0.60, while the private listed firms have 59 with a similar average of 0.68. The average of total inter-industry interlocks is 0.62. Besides, the state-owned listed firms hold 32 banking interlocks with an average of 0.16, whereas the private listed firms hold 19 banking interlocks with an average of 0.22. The average of total banking interlocks is 0.18.
Table 1: Descriptive Statistics of Interlocks in Chinese listed firms Boards Interlock/Average Intra-industry
Interlock/Average Inter-industry Interlock/Average Banking Interlock/Average State-owned Firms 196 239/1.22 122/0.62 117/0.60 32/0.16 Private Firms 87 95/1.09 36/0.41 59/0.68 19/0.22 Total 283 334/1.18 158/0.56 176/0.62 51/0.18
Of the firms studied in the research, although 69% are state-owned firms, the average numbers of various types of interlocks in state-owned firms and private firms are similar.
18 The average of certain variable is measured as variable/Boards, e.g. The average of total interlocks=Total
Table 2 shows the correlations among the variables, as well as their means and standard deviations.
Table 2: The Correlation of Variables
Variables Mean S.D. 1 2 3 4 5 6 7 1. ROA 4.24 5.23 1 2. Interlock 1.18 1.50 -.002 1 3. Intra-industry Interlock 0.56 1.04 .037 .744** 1 4. Inter-industry Interlock 0.62 1.01 -.041 .723** .077 1 5. Banking Interlock 0.18 0.55 -.074 .475** .234** .466** 1 6. State Ownership 35.95 25.24 -.014 .132* .099 .095 .009 1
7. Firm Size 6.48E+10 2.65E+11 -.094 .254** .044 .334** .212** .043 1 8. Firm Age 1996.49 4.57 .170** .062 -.029 .122* -.062 .243** -.023
*. Correlation is significant at the 0.05 level (2-tailed). **. Correlation is significant at the 0.01 level (2-tailed).
From Table 2, no significant correlations between interlocks and ROA can be found. The only variable that has significant correlation with ROA is firm age, which is one of the control variables. Therefore Hypothesis 1 is not supported. The impact of interlocks might be influenced by the ownership structures of the firms, thus in the following tests, ownership structure will be used as moderating variable. Results are illustrated in Table 3.
is still no significance found. However, this time, the results show that the ownership is positively and significantly related to ROA at p<0.05.
Table 3: Regression analysis
Variables
ROA5. Conclusion and Discussion
This study examines the impact of interlocking directorates on performance of 283 Chinese listed firms, of which 196 are state-owned firms, 87 are private firms. Different from early researches that found positive relations between interlocks and firm performance, no significant relationship is found in this analysis. Even using ownership structure as a moderator, no significance is found, indicating that the relationship between interlocks and firm performance is not related to the ownership structures. The non-related results of those hypotheses can be explained from several perspectives.
Firstly, from a corporate governance perspective. Chinese listed firms usually have highly state-owned and concentrated ownership structures, which empower the proprietary shareholder and actual controller great rights to dominate the shareholders’ meeting as well as the board of directors. In addition, board in Chinese listed firms lack of independence, which make the board can’t work effectively. In Chinese firms, interlocking directorates are usually independent directors. The proportion of independent directors is regulated as at least one third of the board members. In deed, most firms just meet this standard. However, decisions made by the board need to be approved by at least half of the board members. Thus one third of the directors are not enough to have a big impact in decision-making of the board. Moreover, the appointment of directors in Chinese firms is dependent on the actual controllers. Therefore, the interlocking directors may neither have effective impact on board decision-making, nor may monitor the board behavior efficiently. Thus, the impact of interlocking directorates may be reduced by the ineffective corporate governance mechanism.
examine the relation between the number of interlocks and firm performance, considering more interlocks indicate more opportunities on acquirement of resources and information. However, one important reason for the firms in China to have interlocks is to embed themselves in the business networks. Some empirical literatures suggest that the position a firm in the network is related to its firm performance (Tsai, 2001; Powell, Koput, Doerr, & Smith, 1999). Compared with the number of interlocks a firm has, its position in the network may be more relevant to the firm performance.
Thirdly, from a guanxi perspective. China is famous of using informal relationship, such as guanxi, as a complement of doing business, or achieving other purposes. Compared with guanxi, interlocks are more formal relations between firms. However, interlocks can be easily observed, whereas guanxi cannot, due to its personal nature. Directors or shareholders may use such guanxi to acquire necessary resources or information for the firms, instead of using interlocks. Therefore, the function of interlocking directorates might be reduced. The prevailing utility of guanxi may also be a reason that interlocks matter little to the firm performance.
Limitation and indication
On one hand, this study examines interlocking directorates from a resource dependency perspective. However it only takes the number of interlocks into consideration. Future studies can combine this with analysis of interlocking network structure, and also examine the influence of interlocks in accordance to the firms’ positions in the network. On the other hand, most firms analyzed in this study are state-owned firms, this may have an influence on the overall results. Nevertheless, due to the different features of state-owned firms and private firms, interlocks in firms with different ownership structures are still worth analyzing. And the corporate governance of Chinese firms also requires further study.
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