Estimating the Extent of Propping in China and How It Is Affected by the Controlling Shareholder’s Capture of Directors and Executives

Estimating the Extent of Propping in China and How It Is Affected by the Controlling Shareholder’s Capture of Directors and Executives

Maggie Williams RMIT University

Dennis William Taylor RMIT University

January 11, 2013
2013 Financial Markets & Corporate Governance Conference

Abstract: 
Research on the phenomenon of propping up a firm’s earnings or liquidity by its controlling shareholders through related-party transactions (RPTs) has suffered from arbitrary and unsettled measures of the ‘propping’ variable and a lack of theoretically underpinning. This study’s first objective is to develop a new measure of propping based on an estimation of the proportion of propping embodied in total related-party transactions. By invoking Jensen and Ruback’s (1983) theory of ‘market for ownership control’, the propping component is estimated from prevailing conditions that can trigger a market for ownership control of a firm or shield its controlling shareholders from this market. Using this theory-based estimate of the extent of propping by a firm, the second objective of this study is to investigate the extent to which controlling shareholders are able to capture directors and top executives in order for the firm’s board governance to facilitate the carrying out of propping transactions. Models are developed and empirically tested in the context of listed companies and securities regulations in China. Using the CSMAR database for the year 201’8 all companies with complete data on the Shanghai and Shenzhen Stock Exchanges are sampled. Results reveal that the key factors deemed to create a market for ownership control – namely, lower State (and State legal person) ownership, greater risk of penalty by the securities regulator and a weaker cushion of non-tradeable shares – are significant conditions affecting total RPTs. The regression coefficients of these factors provide the estimate of the propping component in total RPTs. Over the whole sample propping is found to be approximately 1.5% of total RPTs. This propping measure is then modelled as the dependent variable, and regressed against governance factors that are proxies for the extent of ‘capture’ by controlling State shareholders of directors, supervisors and top executives. The results reveal that the extent of propping is significantly positively affected by the extent of directors’ shareholdings in the firm and the top 3 executives’ emoluments. This paper establishes a new measurement approach that can be adopted in future studies on the phenomenon of propping. It also has practical implications for minority shareholders and prospective investors in terms of developing a firm-level ‘propping’ index and providing a better understanding of how controlling shareholders can ‘capture’ directors and executives to facilitate propping transactions.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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