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Institutional Investors, Political Connections, and the Incidence of Regulatory Enforcement Against Corporate Fraud

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Abstract

We investigate two under-explored factors in mitigating the risk of corporate fraud and regulatory enforcement against fraud, namely institutional investors and political connections. The role of institutional investors in the effective monitoring of a firm’s management is well established in the literature. We further observe that firms that have a large proportion of their shares held by institutional investors have a lower incidence of enforcement actions against corporate fraud. The importance of political connections for enterprises, whether in a developed market such as the United States or an emerging market such as China, has been established by previous studies. However, we find evidence of another positive effect of political connections: they may reduce the incidence of enforcement action against corporate fraud. We also find that political connections play a more significant role in reducing regulatory enforcement incidents against non-state-owned enterprises and firms in weaker legal environments, whereas institutional ownership plays a more important role in reducing regulatory enforcement incidents against state-owned enterprises.

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Notes

  1. There are many examples of institutional investors participating in corporate activities in China, such as nominating new board directors and CEOs. For example, on May 25, 2012, Mr. Feng Jiyong, a candidate for a directorship on the board of Zhuhai Gree Electric Appliances, Inc., was nominated by two institutional investors, the Penghua Fund Company and Yale University Foundation. He was elected to the board of directors of Zhuhai Gree, a company listed on the Shenzhen Stock Exchange (000651.SZ). The candidate who was endorsed by the largest shareholder, the local government of Zhuhai, lost the election (Securities Times 2012).

    Another example relates to a proposal to dismiss the CEO of the Zhejiang Huahai Pharmaceutical Company, a firm listed as 600521.SH on the Shanghai Stock Exchange. The company’s CEO and its largest shareholder, Mr. Chen Baohua, faced a serious conflict with the second-largest shareholder, Mr. Zhou Minghua. The two held 26.8 and 20.2 % of the shares, respectively. At a general shareholder meeting on August 6, 2012, Zhou Minghua put forward a proposal to dismiss Chen Baohua as CEO. However, this proposal was vetoed by the other shareholders, including the mutual funds that played a key role as institutional investors (Money Week 2012).

  2. The amount of assets under management by mutual funds was only US$10 billion by the end of 2002.

  3. We think it is reasonable to generalize the country-level argument of Faccio (2006) to our region-level data, as there is a great heterogeneity of legal environments between the different regions of China, a country with decentralized political, judicial, and economic structures. Moreover, at various times throughout its history, China has been split up into smaller independent countries. This process has shaped the unique characteristics of today’s provinces.

  4. The conclusions still hold when we use the two-dimension clustered standard errors at firm and year level by the approach suggested by Petersen (2009). We thank an anonymous referee for this suggestion.

Abbreviations

CEO:

Chief executive officer

CSRC:

China securities regulatory commission

SOEs:

State-owned enterprises

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Acknowledgements

We thank Edward Lee, Douglas Cumming and Wenxuan Hou (the editors), referees, Yick Ho Yin and participants in “2013 Journal of Business Ethics Special Issue Conference Sustainable and Ethical Entrepreneurship, Corporate Finance and Governance, and Institutional Reform in China” for the helpful comments and suggestions. Wenfeng Wu acknowledges financial support from the National Science Fund Committee of China (No. 71222203). Oliver Rui acknowledges financial support from the National Science Fund Committee of China (71372203) grant and the research grant from CEIBS.

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Authors and Affiliations

  1. Antai College of Economics and Management, Shanghai Jiao Tong University, Shanghai, 200052, China

    Wenfeng Wu

  2. Schulich School of Business, York University, Ontario, Canada

    Sofia A. Johan

  3. Tilburg Law and Economics Center (TILEC), Tilburg, The Netherlands

    Sofia A. Johan

  4. China–Europe International Business School, Shanghai, China

    Oliver M. Rui

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  1. Wenfeng Wu
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Correspondence to Wenfeng Wu.

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Appendix 1

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Wu, W., Johan, S.A. & Rui, O.M. Institutional Investors, Political Connections, and the Incidence of Regulatory Enforcement Against Corporate Fraud. J Bus Ethics 134, 709–726 (2016). https://doi.org/10.1007/s10551-014-2392-4

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