Tunneling or Not? The Change of Legal Environment on the Effect of Post-Privatization Performance

Abstract

Motivated by Hoff and Stiglitz’s (Am Econ Rev 94(3):753–763, 2004) theory, we examine empirically how the creation of “rules of the game” affect the behavior of economic agents in a transition economy. Using a sample of Chinese state-owned enterprises in which controlling ownership was transferred to private acquirers between 1994 and 2006, we find that the post-privatization performance (PPP) of firms depends on institutional factors. Before 2003, we observe severe post-privatization tunneling behaviors by acquirers and worse PPP. However, from 2003, when the State issued regulations against tunneling and strengthened enforcement, the incidence of tunneling behaviors declined, and PPP improved. We find that better implementation of ownership transfer and longer prior experience of private acquirers are key factors that contribute to the improvement.

Appendices

Appendix 1: Variable Definitions

Variable	Definition
From2003	1 if a company was privatized in or after 2003, and 0 otherwise
ΔROA	Average five-year ROA (Return on Assets) after privatization minus average three-year ROA before privatization, adjusted for the change of industry median
ΔROS	Average five-year return on sales after privatization minus average three-year return on sales before privatization, adjusted for the change of industry median
BHAR	Buy-and-hold abnormal return in the 5 years after privatization. The benchmark firm is chosen by: firstly identifying 50 firms with a market capitalization closest to that of a sample firm, then within these 50 firms, identifying the one with the closest market-to-book ratio
ΔOREC	Average five-year other receivables after privatization minus average three-year other receivables before privatization, adjusted for the change of industry median and scaled by total assets
Detected tunneling	1 if an acquirer has been jailed, detained, or received “Penalty Notice” from regulator for tunneling behavior, and 0 otherwise
Connected asset sale	1 if an acquirer sold assets to the privatized firm after privatization, and 0 otherwise
Premature control	1 if an acquirer got controlling rights before a transaction was authorized and fully paid, and 0 otherwise
Inexperienced acquirer	1 if an acquirer has less than 10 years of corporate leadership experience, and 0 otherwise
Industry change	1 if a firm changed its primary business after privatization, and 0 otherwise
ROA before privatization	Average three-year ROA before privatization
Leverage	Total liabilities/total assets at the end of the year before privatization
Size	Natural logarithm of total assets at the end of the year before privatization
Pre-privatization government ownership	Percentage of government ownership of the privatized firm before privatization
Post-privatization government ownership	Percentage of government remaining ownership of the privatized firm after privatization
Post-privatization acquirer ownership	Percentage of acquirers’ ownership of the privatized firm after privatization
MTBR	the ratio of market price to book value of the privatized firm at the end of the year before privatization
Local government controlled	1 if a firm is controlled by local government before privatization, and 0 otherwise
Politically connected acquirer	1 if an acquirer holds a key political position in the provincial or state government, and 0 otherwise
Local acquirer	1 if an acquirer and the privatized firm locate in the same province, and 0 otherwise

1. All continuous financial variables are winsorized at 2 and 98 %

Appendix 2: The Evolution of Regulations against Tunneling in China

Regulations on Restricting Fund Misappropriation

In 2002, due to the concern about fund misappropriation by major shareholders, the China Securities Regulatory Commission (CSRC) launched a general survey on all the 1175 listed companies and found fund misappropriation by controlling shareholders in 676 companies.

In January 2004, China State Council issued Several Opinions on Promoting the Capital Market Reform and Stable Development, which gave specific instructions for resolving the problem of fund misappropriation by major shareholders of listed companies.

In June 2005, CSRC issued the Notice of Resolving Fund Misappropriation and Illegal Guarantees, which required that listed companies work out practical measures to address fund misappropriation and illegal guarantees.

CSRC stated that the problem of fund misappropriation was essentially resolved by the end of 2006 (China Listed Company Corporate Governance Report, 2010).

Regulations on Restricting Related-Party Transactions

In August 2001, CSRC issued The Guidance on the Establishment of the Independent Director System by Listed Companies. The Guidance stipulated that significant related-party transactions (a total value of more than CNY 3 million or more than 5 % of the net asset value) should be approved by independent directors, and there should be at least two independent directors in the board before June 30th, 2002, and that independent directors should be at least 1/3 of board members no later than June 30th, 2003.

In January 2002, CSRC and the National Economic and Trade Commission issued the Code of Corporate Governance of Listed Companies, which reaffirmed the above regulations.

In December 2004, CSRC issued the Provisions on Strengthening the Protection of the Rights and Interests of Public Shareholders. The Provisions requires listed companies to provide an online voting platform for its shareholders for significant asset restructuring in which assets are acquired at a premium of more than 20 % of audited value.

Regulations on Restricting Premature Controlling Rights Transfer

In 2004, CSRC issued the Notification on Supervising Controlling Rights Transfer of Listed Companies. The regulation banned premature transfers of controlling rights before the shares transfers were approved by the government and before the full payment was made.

Appendix 3: List of Convicted Cases of Tunneling in the Sample Period

Before 2003, although there were severe tunneling behaviors by controlling shareholders, none has been arrested or convicted. Starting from 2004, there are multiple cases of people arrested and convicted for tunneling behaviors. Here is a list of convicted cases related privatized firms.

Misappropriated companies	Ticker	Individual names	Time of arrestment/conviction	Crime charged	Sentence
China Sichuan International	600852	CONG Gang	12/2004 6/2006	Contractual Fraud Embezzlement Fund misappropriation	Life imprisonment
Shanxi Jingmi	600092	ZHANG Hua	1/2005 10/2007	Contractual fraud Embezzlement	10 years in prison
Kelon Electrical Holdings	000921	GU Chu-jun	7/2005 1/2008	Fund misappropriation False registered capital Disclosure of false information	10 years in prison
Mingxing Electric Power	600101	ZHOU Yi-ming	12/2005 11/2006	Contractual fraud	Life imprisonment
Xichang Electric Power Zarva Technology	600505 000688	ZHANG Liang-bin	3/2006 12/2007	Embezzlement False capital contribution	16 years in prison
Zhejiang Haina Fujian Sannong Longchang	000925 000732 600772	QIU Zong-bao	2/2006 12/2008	Contractual fraud Fund misappropriation	20 years in prison
Shanghai Broadband Technology	600608	ZHANG Jie	7/2006 9/2007	Injuring listed company	2 years in prison
Kaikai Industry Sanmao Industry	600272 000779	ZHANG Chen	12/2004	Embezzlement Fund misappropriation	Flee away