Abstract
Using data from China’s public debt markets, we study the value of corporate reputation and how it interacts with legal and cultural forces to assure accountability. Exploring lawsuits that change corporate reputation, we find that firms involved in lawsuits experience a decrease in bond values and a tightening of borrowing terms. Using the heterogeneities in legal and social capital environments across Chinese provinces, we find the effects are more pronounced for private firms, firms headquartered in provinces with low legal protections, and firms headquartered in provinces with high social capital. The results show that lawsuits that allege misconduct are associated with reputational penalties and that such penalties serve as substitutes for legal protections and as complements to cultural forces to provide ex post accountability and motivate ex ante trust.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
For example, societies with strong legal institutions could “frame” the societal norms toward opportunism and fraud, for stakeholder expectations rely on taken-for-granted norms embodied within formal regulatory frameworks (Brammer and Jackson, 2012), or vice versa, in the long run, societies with higher social capital may develop strong legal institutions (Greif, 1993). Moreover, strong legal and social institutions are important antecedents of market development, which amplify the value of firms’ (market-based) reputational capital.
Note that lawsuits could harm the reputation of plaintiff firms as well. It is because litigation may reveal a hitherto unknown business dispute with stakeholders (indeed, it is not uncommon that some plaintiffs later become defendants because of the counter-claims). Moreover, under the institutional environment of China, litigation is often the last resort in dispute resolution. Even if the company is the plaintiff, others tend to interpret litigation as a broken business relationship, or failures to resolve a dispute in peaceful manner. Section 4 provides empirical evidence.
Prior work using lawsuits in event study shows lawsuit announcements reduce shareholder wealth (Bhagat, Bizjak, and Coles, 1998; Bhagat, Brickley, and Coles, 1994; Griffin, Grundfest, and Perino, 2004; Haslem, Hutton, and Smith, 2017; Karpoff and Lott, 1993; Karpoff, Lott, and Wehrly, 2005; Raghu et al., 2008). Among the few research on bondholders, Billings, Klein, and Zur (2011) find negative bond returns and excess trading volume around securities class actions.
For example, there are eight Chinese provinces with populations comparable to Italy (60.5 million), France (65 million), and UK (68 million). They are Guangdong (104 million), Shandong (100 million), Henan (94 million), Sichuan (81 million), Jiangsu (79 million), Hebei (72 million), and Hunan (66 million), and Anhui (60 million). In terms of nominal GDP in 2018, the provinces of Guangdong and Jiangsu are comparable to Spain, Shandong province is comparable to the Netherlands, Zhejiang province is comparable to Switzerland, and Sichuan province is comparable to Sweden.
La Porta et al. (2008) argue that the common law legal origin stands for a strategy that seeks to support private market outcomes, whereas civil law seeks to replace such outcomes with state-desired allocations.
From 2006 to 2015, the number of concluded court cases per year swelled from 8.55 million to 16.7 million (Supreme People’s Court Work Report).
See Chapter 11.1 of Listing Rule of the Shanghai Stock Exchange (1998) and Listing Rule of the Shenzhen Stock Exchange (1998).
We exclude the countries with fewer than 11 million people and with a GDP of less than US$50 billion. Data are from the latest version of the World Bank Global Financial Development database:
https://datacatalog.worldbank.org/dataset/global-financial-development
On January 15, 2015, the CSRC and Shanghai Stock Exchange announced a new corporate bond issuance reform that allows unlisted firms to issue corporate bonds in the stock exchanges. However, before this reform, unlisted firms were only allowed to issue small- and medium-size enterprise (SME) bonds through private placement, and only listed firms could issue bonds publicly in this market.
For example, 82% of the bonds traded in the enterprise bond market are Chengtou bonds (“Municipal Investment Bonds”) by 2017.
According to the rules of the Shanghai and Shenzhen stock exchanges, wealthy individual investors with financial assets (including stocks, bonds, mutual funds, and bank wealth-management products) over RMB 3 million are allowed to trade corporate bonds in the exchange markets. Starting in February 2016, the People’s Bank of China allowed wealthy individuals with financial assets over RMB 3 million to participate in the interbank market.
This article focuses on 451 lawsuits that involve bond issuers. We nevertheless provide a summary description of the 8,531 lawsuits as follows: The number of lawsuits increased from 27 in 1998 to 1,186 in 2013. Among the lawsuits, 36.9% (3,145 cases) relate to loans (bank or intercorporate loans), and 31.2% (2,722 cases) relate to torts, including fraud and securities actions, product liability, intellectual property infringement, share disputes, environmental damage, bribery, embezzlement, and administrative lawsuits against the government, etc. The remaining 31.9% (2,664 cases) relate to contracts incidental to business operations—for example, disputes over contracts on sales and purchases, construction projects, leasing, procurement, licensing, transportation, etc. There is a strong representation of SOEs and POEs among both plaintiffs and defendants. SOEs are plaintiffs in 1,394 cases and defendants in 2,565 cases; POEs are plaintiffs in 1,124 cases and defendants in 3,448 cases.
Note that some issuers have multiple bonds, although the majority of issuers have only one bond outstanding.
Spread is calculated using the difference between the at-issue bond yield and the three-year Chinese treasury bonds yield matched based on issuance date, because 70% of the corporate bonds in our sample have the maturity of three or five years. We also use the five-year Chinese treasury bond matched on issuance date, and the results are similar. For robustness test, we also use the difference between the at-issue bond yield and that of the same maturity treasury bonds based on the issuance date; the results are qualitatively unchanged.
We follow the conventional literature (Clermont and Eisenberg, 1992; Kessler, Meites, and Miller, 1996) and define plaintiff “success” as when a plaintiff receives monetary benefit at trial. Data show that it is typical for Chinese courts to support or reject plaintiff claims in full. For robustness check, we use the proportion of the trial award to the plaintiff’s monetary claims as an alternative “win” proxy and find that this does not change the results qualitatively.
To be sue, the Chinese law does not allow direct intercorporate loans. To assess credit, many firms engage in intercorporate lending through “entrusted loans” using banks as an intermediary. For a representative case study, in Shenzhen Development Bank (SDB) v. Wanghai Yikang Development Ltd. (WYD), SDB sued WYD, a real estate company, for an RMB 220 million bank loan default in 2004. The loan was guaranteed by China Railway Construction Engineering Group (CRCE), a subsidiary company of China Railway Group (CRG, the issuer). The case was heard in the high court of Guangdong province in 2007, and WYD lost the case. CRCE appealed in 2007, and CRG made a public announcement about this lawsuit on April 29, 2009. In the end, the court directed an arrangement between WYD and its creditors (including CRCE) under the Bankruptcy Law of 2007. The guarantor’s liability was eventually discharged. CRG later issued a corporate bond in October 2010.
For a representative case study, in COFCO Property v. Great China International Group (GCIG), COFCO Property (the issuer), a real estate subsidiary of China Oil and Foodstuffs Corporation, sued GCIG on April 8, 2011, to enforce an estate sale and purchase agreement. The case was resolved through mediation by the high court of Guangdong province. COFCO Property successfully acquired the property ownership at the price of around RMB 300 million. COFCO Property publicly announced this lawsuit on November 30, 2012. COFCO Property later issued a corporate bond in August 2015.
For a representative case study, in Hongfujin Precision Industry (HPI) v. BYD Company Limited (BYD), HPI, a subsidiary of Taiwan-based technology company Foxconn, sued BYD for infringing commercial secrets and inducing employees to breach their confidentiality agreements. The case was heard by the high court of Hong Kong SAR in 2012, and HPI eventually withdrew the case. BYD publicly announced this lawsuit in August 2013. BYD issued multiple corporate bonds in 2012, 2013, and 2015.
When applying the propensity score matching, we first estimate a logit model based on the whole sample of firms with non-missing matching variables in the year prior to the litigation. In the logit model, the dependent variable is a dummy showing whether the issuer is litigated; the explanatory variables are firm characteristics, including firm size, age, tangibility, leverage, profitability, and industry and year dummies. Then we choose a bond with the closest propensity score without replacement for each treated bond as the control bond.
We report the result of both the full sample and the sample excluding plaintiffs, because prior event studies on the effects of corporate lawsuit in China (e.g., Firth et al., 2011) find that litigation announcements depress the stock prices of both defendant and plaintiff firms. Moreover, we hypothesize that lawsuits could harm the reputational capital of the plaintiff firms as well. This is because lawsuit reveals a hitherto unknown business dispute with stakeholders (Indeed, it is not uncommon that some plaintiffs later become defendants because of the counterparty claims). It may reveal firms’ agency risk, broken business relationships, and other unethical behaviors. Under the institutional environment of China, litigation is often seen as the last resort in dispute resolution. Even if the company is the plaintiff, others tend to interpret litigation as a broken of business relationship, or failures to resolve a dispute in peaceful manner. This revised belief can also cause the value of firms’ future surplus to decrease, which fits into the definition of reputational capital.
We also try a smaller sample keeping one bond for each firm. In order to do so, we follow Klein and Zur (2011), and we keep the most recently issued bond as the representative bond for the firm. The results are in appendix Table A.6. We find consistent evidence that bonds from litigated firms have on average significantly higher yield spreads at issuance.
Here, including plaintiffs does not change our results about how the effects of lawsuits rely on case outcome and lawsuit type. For brevity, we only report the results using the sample of defendants in the table.
However, because the number of lawsuits are missing for some provinces, the variable High lawsuits has fewer observations.
Results are similar when we use the sample median to split strong and weak rule-of-law provinces.
For a robustness test, we use the average from 2010 to 2015; the results are similar across those years.
China’s blood donation law states that only the National Blood Center (NBC) can collect blood and without compensation. The NBC has operating branches in all provinces and adopts the same medical procedures across all regions, thereby mitigating the concern that differences in the quality of healthcare or medical infrastructure among provinces affect blood donation levels.
For robustness, we also split the sample using High Blood and High rice wheat in Panel A, and the results are consistent. The same for Panel B and C of Table 7.
For the matching algorithm for the bond return sample, in the logit model, the dependent variable is a dummy showing whether the issuer is litigated; the explanatory variables are bond features including rating, time to maturity, and coupon rate, given that the existing securities terms are more likely to determine the price.
We also test with longer event windows [-3, + 3] and [-5, + 5]. The untabulated results show the effect for bond return vanishes; however, the effect on excess bond daily trading remains significant at the 1% level.
For EBR, we follow the method in Billings, Klein et al. (2011). EBR is the difference between the raw return for the bond in the lawsuit sample over an event window and its control bond. The daily clean bond return is daily bond price changes. Daily bond return is daily price change plus accrued interest. Raw return is the total cumulative bond return over the period beginning at a set number of trading days before the announcement date and ending on the same number of trading days after the announcement date.
For ABR, we employ a mean-adjusted return model that accounts for changes in the term structure (Handjinicolaou and Kalay, 1984; Maxwell and Stephens, 2003). We first calculate a bond’s premium holding period return (PBR) as the difference in a bond’s raw daily return and duration-equivalent treasury security. We then use this PBR to calculate the average expected excess return as the average PBR for the month before the announcement date. The ABR is the difference in PBR around the announcement and the expected excess bond returns.
The negative excess bond return (EBR) of the bonds with litigation vanishes when we expand the window to 7 or 11 days. The effect is similar for abnormal bond return (ABR).
References
Allen, F., Qian, J., & Qian, M. (2005). Law, finance, and economic growth in China. Journal of Financial Economics, 77(1), 57–116.
Amstad, M, & He, Z. (2019). Chinese bond market and interbank market, NBER Working Paper No. 25549.
Ang, J. S., Cheng, Y. M., & Wu, C. P. (2015). Trust, investment, and business contracting. Journal of Financial and Quantitative Analysis, 50(3), 569–595.
Armour, J., Mayer, C., & Polo, A. (2017). Regulatory sanctions and reputational damage in financial markets. Journal of Financial and Quantitative Analysis, 52(4), 1429–1448.
Bae, K. H., & Goyal, V. K. (2009). Creditor rights, enforcement, and bank loans. The Journal of Finance, 64, 823–860.
Bhagat, S., Bizjak, J., & Coles, J. L. (1998). The shareholder wealth implications of corporate lawsuits. Financial Management, 27, 5–27.
Bhagat, S., Brickley, J. A., & Coles, J. L. (1994). The costs of inefficient bargaining and financial distress: Evidence from corporate lawsuits. Journal of Financial Economics, 35, 221–247.
Billings, K., and Zur. (2011).
Bottazzi, L., Da Rin, M., & Hellmann, T. (2016). The importance of trust for investment: Evidence from venture capital. Review of Financial Studies, 29(9), 2283–2318.
Brady, J., Evans, M. F., & Wehrly, E. W. (2019). Reputational penalties for environmental violations: A pure and scientific replication study. International Review of Law and Economics, 57, 60–72.
Brammer, S., & Jackson, G. (2012). How regulatory institutions influence corporate reputations: A cross-country comparative approach. In M. L. Barnett & T. G. Pollck (Eds.), The Oxford handbook of corporate reputation. Oxford University Press.
Carroll, C. E., & Olegario, R. (2020). Pathways to corporate accountability: Corporate reputation and its alternatives. Journal of Business Ethics, 163, 173–181.
Chava, S., Huang, K., Johnson, S. A. (2017). The dynamics of borrower reputation following financial misreporting, Management Science, forthcoming.
Chen, D., Deakin, S., Siems, M., & Wan, B. (2017). Law, trust and institutional change in China: Evidence from qualitative fieldwork. Journal of Corporate Law Studies, 17(2), 257–290.
Cherian, J., J. Mo, & Subrahmanyam, M. (2019). China’s corporate bond market: Development and policy issues. NYU Stern Working Paper.
Clermont, K. M., & Eisenberg, T. (1992). Trial by jury or judge: Transcending empiricism. Cornell Law Review, 77, 1124–1177.
Coleman, J. (1988). Social capital in the creation of human capital. American Journal of Sociology, 94, 95–120.
Dahiya, S., John, K., Puri, M., & Ramirez, G. (2003). Debtor-in-possession financing and bankruptcy resolution: Empirical evidence. Journal of Financial Economics, 69(1), 259–280.
Deng, S. Y., Willis, R. H., & Xu, L. (2014). Shareholder litigation, reputational loss, and bank loan contracting. Journal of Financial and Quantitative Analysis, 49(4), 1101–1132.
Denis, D. J., & Wang, J. (2014). Debt covenant renegotiations and creditor control rights. Journal of Financial Economics, 113(3), 348–367.
Diamond, D. W. (1991). Monitoring and reputation: The choice between bank loans and directly placed debt. Journal of Political Economy, 99(4), 689–721.
Dupont, Q., & Karpoff, J. M. (2020). The trust triangle: Laws, reputation and culture in empirical finance research. Journal of Business Ethics, 163(2), 217–238.
Elster, J. (1989). Social norms and economic theory. Journal of Economic Perspective., 3, 99–117.
Faccio, M. (2006). Politically connected firms. American Economic Review, 96, 369–386.
Faccio, M., Masulis, R. W., & McConnell, J. J. (2006). Political connections and corporate bailouts. Journal of Finance, 61, 2597–2635.
Fan, G., Wang, X. L., & Zhu, H. P. (2011). NERI INDEX of marketization of China’s provinces. Economic Science Press.
Fan, P. H., Joseph, T. J. W., & Zhang, T. Y. (2013). Institutions and organizational structure: The case of state-owned corporate pyramids. Journal of Law, Economics, and Organization, 29, 1217–1252.
Firth, M. A., Rui, O. M., & Wu, W. (2011). The effects of political connections and state ownership on corporate litigation in China. The Journal of Law and Economics, 54(3), 574–607.
Fisman, R. (2001). Estimating the value of political connections. American Economic Review, 91, 1095–1102.
Fombrun, C. J. (2012). The building blocks of corporate reputation: Definitions, antecedents, consequences. In M. L. Barnett & T. G. Pollock (Eds.), The Oxford handbook of corporate reputation. Oxford University Press.
Fukuyama, F. (1995). Social capital and the global economy. Foreign Affairs, 74, 89–103.
Gow, I., Wahid, A., & Yu, G. (2018). Managing reputation: Evidence from biographies of corporate directors. Journal of Accounting Economics, 66, 448–469.
Graham, J. R., Li, S., & Qiu, J. (2008). Corporate misreporting and bank loan contracting. Journal of Financial Economics, 89(1), 44–61.
Greif, A. (1993). Contract enforceability and economic institutions in early trade: The Maghribi traders’ coalition. The American Economic Review, 83(3), 525–548.
Griffin, P. A., Grundfest, J. A., & Perino, M. A. (2004). Stock price response to news of securities fraud litigation: An analysis of sequential and conditional information. Abacus, 40(1), 21–48.
Guiso, L., Sapeinza, P., & Zingales, L. (2004). The role of social capital in financial development. American Economic Review, 94, 526–556.
Guiso, L., Sapeinza, P., & Zingales, L. (2008). Trusting the stock market. Journal of Finance, 63, 2557–2600.
Handjinicolaou, G., & Kalay, A. (1984). Wealth redistributions or changes in firm value: An analysis of returns to bondholders and stockholders around dividend announcements. Journal of Financial Economics, 13(1), 35–63.
Hasan, I., He, Q., & Lu, H. (2021). Social capital, trusting, and trustworthiness: Evidence from peer-to-peer lending. Journal of Financial and Quantitative Analysis. https://doi.org/10.2139/ssrn.3724087
Hasan, I., Hoi, C. K., Wu, Q., & Zhang, H. (2017). Does social capital matter in corporate decisions? Evidence from corporate tax avoidance. Journal of Accounting Research, 55(3), 629–668.
Haslem, B., Hutton, I., & Smith, A. H. (2017). How much do corporate defendants really lose? A new verdict on the reputation loss induced by corporate litigation. Financial Management, 46(2), 323–358.
Hribar, P., & Jenkins, N. T. (2004). The effect of accounting restatements on earnings revisions and the estimated cost of capital. Review of Accounting Studies, 9(2), 337–356.
Iacobucci, E. M. (2014). On the interaction between legal and reputational sanctions. Journal of Legal Studies, 43(1), 189–207.
Kale, J. R., & Meneghetti, C. (2011). The choice between public and private debt: A survey. IIMB Management Review, 23(1), 5–14.
Karpoff, J. M., & Lott, J. R. (1993). The reputational penalty firms bear from committing criminal fraud. Journal of Law and Economics, 36(2), 757–802.
Karpoff, J. M. (2012). Does reputation work to discipline corporate misconduct? In M. L. Barnett & T. G. Pollck (Eds.), The Oxford handbook of corporate reputation. Oxford University Press.
Karpoff, J. M., Lee, D. S., & Martin, G. S. (2008). The cost to firms of cooking the books. Journal of Financial and Quantitative Analysis, 43(3), 581–611.
Karpoff, J. M., Lee, D. S., & Vendrzyk, V. P. (1999). Defense procurement fraud, penalties, and contractor influence. Journal of Political Economy, 107(4), 809–842.
Karpoff, J. M., Lott, J. R., & Wehrly, E. W. (2005). The reputational penalties for environmental violations: Empirical evidence. Journal of Law and Economics, 48(2), 653–675.
Kessler, D., Meites, T., & Miller, G. (1996). Explaining deviations from the fifty-percent rule: A multimodal approach to the selection of cases for litigation. The Journal of Legal Studies, 25(1), 233–259.
Klein, B., & Leffler, K. B. (1981). The role of market forces in assuring contractual performance. Journal of Political Economy, 89(4), 615–641.
Klein, A., & Zur, E. (2011). The impact of hedge fund activism on the target firm’s existing bondholders. Review of Financial Studies, 24(5), 1735–1771.
Landry, P. (2008). The institutional diffusion of courts in China. In T. Ginsburg & T. Moustafa (Eds.), Rule by law: The politics of courts in authoritarian regimes (pp. 207–234). Cambridge: Cambridge University Press.
La Porta, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. W. (1998). Law and finance. Journal of Political Economy, 106(6), 1113–1155.
La Porta, Lopez-de-Silanes, and Shleifer. (2008).
Li, H., Meng, L., Wang, Q., & Zhou, L. A. (2008). Political connections, financing and firm performance: Evidence from Chinese private firms. Journal of Development Economics, 87(2), 283–299.
Lin, T., Pursiainen, V., 2018. Fund what you trust? Social capital and moral hazard in crowdfunding. https://ssrn.com/abstract=3088905.
Lu, H. T., Pan, H. B., & Zhang, C. Y. (2015). Political connectedness and court outcomes: Evidence from Chinese corporate lawsuits. Journal of Law and Economics, 58(4), 829–861.
Luoma-aho, V. (2015). Corporate reputation and the theory of social capital. In C. E. Carroll (Ed.), The handbook of communication and corporate reputation. New York: Wiley.
Maxwell, W. F., & Stephens, C. S. (2003). The wealth effects of repurchases on bondholders. Journal of Finance, 58(2), 895–920.
Murphy, D., Shrieves, R. E., & Tibbs, S. L. (2009). Understanding the penalties associated with corporate misconduct: An empirical examination of earnings and risk. Journal of Financial and Quantitative Analysis, 44(1), 55–83.
Nelson, K., Price, R., & Rountree, B. (2008). The market reaction to Arthur Andersen’s role in the Enron scandal: Loss of reputation or confounding effects? Journal of Accounting and Economics, 46, 279–293.
Pevzner, M., Xie, F., & Xin, X. G. (2015). When firms talk, do investors listen? The role of trust in stock market reactions to corporate earnings announcements. Journal of Financial Economics, 117, 190–223.
Qian, J., & Strahan, P. E. (2007). How laws and institutions shape financial contracts: The case of bank loans. The Journal of Finance, 62, 2803–2834.
Raghu, T. S., Woo, W., Mohan, S. B., & Rao, H. R. (2008). Market reaction to patent infringement litigations in the information technology industry. Information Systems Frontiers, 10(1), 61–75.
Rajan, R. G. (1992). Insiders and outsiders: The choice between informed and arm’s-length debt. The Journal of Finance, 47, 1367–1400.
Roberts, M. R., & Sufi, A. (2009). Renegotiation of financial contracts: Evidence from private credit agreements. Journal of Financial Economics, 93(2), 159–184.
Stiglitz, J. E., & Weiss, A. (1981). Credit rationing in markets with imperfect information. American Economic Review, 71(3), 393–410.
Talhelm, T., Zhang, X., Oishi, S., Shimin, C., Duan, D., Lan, X., & Kitayama, S. (2014). Large-scale psychological differences within China explained by rice versus wheat agriculture. Science, 344(6184), 603–608.
Uzzi, B. (1997). Social structure and competition in interfirm networks. Administrative Science Quarterly, 42(1), 37–69.
Wang, Q., Wong, T. J., & Xia, L. J. (2008). State ownership, the institutional environment, and auditor choice: Evidence from China. Journal of Accounting and Economics, 46, 112–134.
Woolcock, M. (1998). Social capital and economic development: Toward a theoretical synthesis and policy framework. Theory and Society, 27(2), 151–208.
Funding
Funding was provided by Hong Kong Sustaintech Foundation, Research Grants Council, University Grants Committee [Grant No. 15605715] and National Natural Science Foundation of China [Grant No. 71703181].
Author information
Authors and Affiliations
Corresponding author
Additional information
Publisher's Note
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
Supplementary Information
Below is the link to the electronic supplementary material.
Rights and permissions
About this article
Cite this article
Gu, X., Hasan, I. & Lu, H. Institutions and Corporate Reputation: Evidence from Public Debt Markets. J Bus Ethics 183, 165–189 (2023). https://doi.org/10.1007/s10551-021-05020-x
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10551-021-05020-x