Journal of Corporate Finance

Journal of Corporate Finance

Ownership structure, corporate governance, and fraud: Evidence from China

Our study examines whether ownership structure and boardroom characteristics have an effect on corporate financial fraud in China. The data come from the enforcement actions of the Chinese Securities Regulatory Commission. The results from univariate analyses, where we compare fraud and no-fraud firms, show that ownership and board characteristics are important in explaining fraud. However, using a bivariate probit model with partial observability we demonstrate that boardroom characteristics are important, while the type of owner is less relevant. In particular, the proportion of outside directors, the number of board meetings, and the tenure of the chairman are associated with the incidence of fraud. Our findings have implications for the design of appropriate corporate governance systems for listed firms. Moreover, our results provide information that can inform policy debates within the Chinese Securities Regulatory Commission. All rights reserved.

One. Introduction

China began a process of economic restructuring in the late nineteen seventies and these reforms continue to this day. Principal aims of the reforms include the modernization of industry, stimulation of growth, reduction of poverty, and improvements in economic efficiency. To implement these reforms, China has moved towards a free-enterprise system that has included, among other things, the privatization of many state-owned enterprises, the formation of joint stock companies, and the development of stock markets. The trials and tribulations of the reform process have been well documented and analyses of the effectiveness of these reforms have begun to appear in the literature. In a detailed analysis of national economic statistics, Allen et al. conclude that it is the private non-listed sector of the economy that has driven China's economic growth. They argue that poor governance has constrained the performance of listed firms. Chen et al. concur with the arguments of Allen et al. and they further demonstrate that the performance of partially privatized state-owned enterprises deteriorates in the years after the initial public offering.

China's reform process has been gradual and contrasts with the wholesale and 'overnight' reforms undertaken in many ex-Soviet-bloc countries. The reforms have borrowed concepts and "best practices" from the United States and other capitalist nations. For example, the governance of listed firms follows, in many respects, practices from the United Kingdom and the United States. Firms have boards of directors who are charged with running the organization and the chairman of the board is the main power and takes on an executive role. Boards are required to have outside directors although, only recently, have they been required to be independent. Appointment committees, compensation committees, and other committees are now becoming common in Chinese listed firms. Although there is widespread adoption of western corporate governance practices, the effectiveness of them has yet to be fully evaluated. The particular issue we examine in this study is whether the style and form of corporate governance has an effect in deterring financial fraud. Our research follows the line of enquiry of Beasley but does so in a major transition economy, namely China.

The China Securities Regulatory Commission is charged with enforcing all aspects of the securities laws in China and its powers and operations are not dissimilar to those of the Securities and Exchange Commission in the United States. The China Securities Regulatory Commission investigates allegations of corporate and securities fraud and makes enforcement actions in cases where fraud and malpractices are proved. We examine these enforcement actions and develop a model to explain why some firms succumb to financial fraud while others do not. In particular, we examine whether the ownership and governance structures of firms have an impact on the propensity to commit fraud.

Our study contributes to the literature in the following ways. First, China has a relatively underdeveloped legal environment when compared to the United States and so the role and impact of regulation and corporate governance differs across the two countries. We compare China to the United States because most prior research has used data from American enforcement actions. La Porta et al. and Roe show that the legal environment of a country has a significant impact on firm performance and corporate governance. In China, civil litigation is very rare and thus the regulator, in this case the China Securities Regulatory Commission, is the prime discipliner of firms and their managements. In contrast, in the United States, legal actions against firms can be criminal, for example the Securities and Exchange Commission, and/or civil, for example shareholder class action lawsuits. The threat of civil litigation is a major factor in influencing corporate behavior in the United States. Second, the ownership structure of listed firms in China is unique. For example, blockholders are usually the state and quasi-state institutions, such as state-owned enterprises, and we investigate if they have an impact on corporate fraud. These blockholders are very different from those in the United States or Europe and so they have different influences on the firm. Third, while Chinese boardrooms have similar setups to those in western companies, their dynamics are quite different. For example, chairmen are full-time executives and they wield significant power. As another example, senior management typically started their careers as government bureaucrats and so they may have different mindsets than top executives in United States firms. We examine specific boardroom characteristics including outside directors, board size, number of board meetings in a year, chairman tenure, and chairman/CEO duality to see if they help explain the incidence of enforcement actions. Fourth, China's auditing profession is relatively new and it has faced a steep learning curve. We examine whether certain audit firms are more likely to deter fraud. Fifth, we employ bivariate probit regression with partial observability to model the multivariate relationships with fraud. One problem of the existing approach to modeling corporate fraud is that we can only observe fraud that is detected. Bivariate probit with partial observability allows us to model the observed outcome, detected fraud, as a function of the joint realizations of the propensity to commit fraud and the probability of detection. Our results provide some inputs for the deliberations of policy makers and regulators as they review the effectiveness of current laws and procedures and as they consider extensions and improvements to the regulations.

In the multivariate tests we find that firms that have a high proportion of non-executive directors on the board are less likely to engage in fraud. This evidence is consistent with outside directors monitoring the actions of managers and thus helping deter fraudulent acts. Firms that have chairmen with shorter tenures are associated with higher incidences of fraud. Short-tenure may imply the chairman lacks experience in the firm and so deterring fraud is more difficult. Board meeting frequency is positively associated with fraud. This may imply that a firm's questionable or illegal activities where discussed by the board over a number of meetings. There is weak evidence from the multivariate analysis that firms where one person occupies the positions of both the chairman and the CEO have higher frequencies of fraud. This finding is consistent with the argument that handing one person a lot of power, chairman and CEO positions, makes it easier for that person to abuse their power and engage in fraudulent activities. Duality of chairman and CEO positions reduces the checks and balances in the top management of the firm.

Ownership characteristics appear to be less important in explaining fraud. Legal entity stockholders are positively associated with fraud although only the univariate analysis, which compares fraud and no-fraud firms, is statistically significant. Legal entity investors, such as parent state-owned enterprises, are charged with making profits and so they may encourage listed firms in which they are invested to falsify their financial statements and engage in fraud. We also find that firms with foreign shareholders are less likely to have enforcement actions against them. We believe foreigners monitor the firms they invest in and this helps deter fraud. However, the importance of ownership characteristics disappears in the multivariate setting.

The paper proceeds as follows. First, we give a brief discussion of China's enterprise reforms and the workings of CSRC (Section Two). Section Three describes our research design, introduces the sample data, and develops testable hypotheses. The results are reported and discussed in Section Four and our conclusions are presented in Section Five.