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Blockholder exit threats in the presence of private benefits of control

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Abstract

Exit theory predicts a governance role for outside blockholders’ exit threats, but this role could be ineffective if managers’ potential private benefits exceed their loss in stock-price declines caused by the blockholders’ exits. We test this prediction using the Split-Share Structure Reform (SSSR) in China, which provided a large exogenous and permanent shock to the cost for outside blockholders to exit. We find that firms whose outside blockholders experience an increase in exit threats improve performance more than those whose outside blockholders experience no increase. The governance effect of exit threats also is ineffective in the group of firms with the highest concern for private benefits of control. Finally, a battery of theory-motivated tests shows that the documented effects are unlikely explained by outside blockholder intervention or some well-known intended effects of SSSR.

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Notes

  1. We use the term “outside blockholders” to refer to blockholders who are not involved in management and not closely related to the managers and “inside blockholders” to refer those who are either managers or closely related to the managers.

  2. Norli et al. (2015) report that liquidity improves activism because activists can benefit through informed trading.

  3. According to Dyck and Zingales (2004, p. 541), private benefits of control refer to “some value, whatever the source, is not shared among all the shareholders in proportion of the shares owned, but it is enjoyed exclusively by the party in control.”

  4. What we document is likely to be the net effect of increased liquidity on firm performance, combining reduced activism and increased exit threats.

  5. Several arguments have been made about the negative effects of the split-share structure (and thus the potential benefits of the reform). First, because the shares were nontradable, holders could not directly benefit from price appreciation, and thus their incentives for value creation were reduced. Second, the existence of nontradable shares made shares illiquid because the public float for a listed company is often small. Third, the nontradable nature of the shares made it difficult for outsiders to accumulate them and obtain corporate control, exacerbating the entrenchment problem.

  6. See http://finance.sina.com.cn/stock/y/ 20,050,516/08251589236.shtml.

  7. In another study, Chen and Xiong (2001) examine 2819 nontradable-share transactions and document a mean discount of 77.93%, based on auctions and 85.59% based on private transfers.

  8. All inferences remain unchanged if we exclude these observations or include them in the control sample.

  9. Matching annually helps to fully remove the differences in treatment and control groups across the matching dimensions. Our inferences are not sensitive to this choice.

  10. CSRC’s industry classification includes two levels. At Level 1, all the listed companies are classified into 19 types. At Level 2, they are further divided into 90 industries.

  11. The number of observations reaches the peak in year 2006 because we require nonmissing values in the variables used in our main regression, and we use lagged ROA as a control variable (with ROA defined as return on lagged assets).

  12. According to Liao et al. (2014), there were 1315 firms with split-share structure before the reform. In our sample, 1293 firms had started the reform by the end of 2006. The late movers usually had unusual difficulties in carrying out the reform. Nevertheless, our inferences remain the same if we include the eight firms that started the reform in 2007.

  13. After decomposing ROA into profit margin and asset turnover, we find that the main effect comes from profit margin (significant at the 1% level), but asset turnover also improves (although insignificantly) more in the treatment firms than in control firms after the SSSR. Also, the treatment firms have a significantly greater improvement in sales growth (significant at the 1% level). In terms of economic significance, we witness improvements of 16.9%, 4.6%, and 4.3% for the treatment firms, compared to pre-SSSR sample average for profit margin, asset turnover, and sales growth, respectively.

  14. For example, assume that Firm X has two shareholders, A and B. A holds 30% of X, and B holds 20% of X. In addition, A holds 50% of B. As a result, the cash-flow rights that A has are 30% + 20%*0.5 = 40%, while the voting rights that A has are 30% + 20% = 50%. Thus there is a wedge of 10%. If the controlling shareholders have high voting rights but low cash-flow rights, any action taken to benefit themselves at the expense of other equity holders has a lower relative cost to them.

  15. 34.4% of the PSM sample firm-years have Separation equal to 0. In addition, Separation should be high enough to make a difference in incentives, which is why we focus on the firms with high Separation. We use 10% as the cut-off point, which corresponds to the 78th percentile.

  16. Private benefits of control and wealth sensitivity are both moderators to the effectiveness of exit threats. We emphasize private benefits more than wealth sensitivity because they highlight the uniqueness of the Chinese setting, and doing so answers the call from Edmans (2014) and Edmans and Holderness (2016) to study the interaction between private benefits of control and exit threats. In comparison, the role of wealth sensitivity is well established in the literature.

  17. One criticism against using managers’ wealth sensitivity to identify exit threats is as follows: to the extent managers have more at stake, they could be more likely to follow blockholders’ value-increasing advice. As a result, we caution readers to interpret these results accordingly.

  18. Note that some control firms are matched to both the Multiple Outside Blockholder sample and the Single Outside Blockholder sample. As a result, the sum of observations in Columns 3 and 4 is larger than that in the main test (4947 + 6208 = 11,155 > 9840 in Table 2).

  19. Our inferences are robust to controlling for the total shares held by all blockholders.

  20. Note that this section shows that our results are not explained by the intervention of new blockholders formed after the liquidity shock as modeled by Maug (1998). We examine the effect of existing blockholders in other tests.

  21. As discussed in Section 2, no trading restrictions are removed within the first 12 months of reform completion and only up to 5% of the converted shares could be sold in the next 12 months. Thus, even if the reform is announced and completed in the same year for a firm, at most 5% of the nontradable shares become tradable in PERIOD1.

  22. We acknowledge the possibility that outside blockholders could intervene in a less costly way through advising managers privately, instead of fighting in shareholder meetings. Empirically, we can only focus on the observable dimensions. Although there exist other types of intervention, vetoing management proposals clearly indicates intervention.

  23. We consider the activeness of independent directors as an important indicator of board atmosphere. Although we cannot identify the connection between independent directors and outside blockholders, more active independent directors suggest that the board is less anti-activist.

  24. Most of these loans did not accrue interest and the principal was typically never paid back. Jiang et al. (2010) show that the firms in the top OREC deciles are much more likely to experience financial distress within two years compared with other firms. This extreme form of tunneling was greatly reduced by government interventions in 2006.

  25. Untabulated results indicate that SGA is not significantly higher in the treatment sample than in the control sample in any year before the SSSR; however, OREC is significantly higher in the control sample in 2000 and 2001 and the difference totally disappears in year 2004—the year right before the SSSR. These statistics suggest the importance of considering the agency-problem explanation. Furthermore, we acknowledge the possibility that including SGA, OREC, and their interactions with POST may fully control for the agency channel.

  26. We also find that our results are not driven by inside blockholders’ care for their property rights. Our treatment firms have significantly smaller managerial block ownership in 2004 than the control group (34.2% versus 51.8%). The property-rights mechanism predicts a larger treatment impact among the firms with larger controlling shareholders and thus a stronger effect for our control group. We find the opposite results, suggesting that the treatment effect we document cannot be fully explained by the property-rights effect. Moreover, we control for the holdings of controlling shareholders (ConOwn) and the interaction between ConOwn and POST in all regressions.

  27. Please note that state blockholders have the incentive to exit and have shown evidence of frequent sales in the data. According to block-sales statistics from 2006 to 2013 (May), 34% of the 1726 block sales (i.e., more than 1% of the firms’ shares) are done by state blockholders (Wu 2017). For this reason, in our main specification, we include the State_TREAT firms in the treatment group.

  28. IndROA is widely used in the literature (e.g., Eisenberg et al. 1998; Masulis and Mobbs 2014) because it provides a relative metric of performance and because it helps to adjust the right skewness of ROA.

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Acknowledgements

We would like to thank Mahfuz Chy, Alexander Dyck, Vivian Fang (MIT/Asia discussant), Michael Firth, José Miguel Gaspar, Danqi Hu, Michael Iselin (FARS discussant), Yue Li, Ross Lu, Robert Parrino (NFA discussant), Stephen Penman (Editor), Tiago Pinheiro, Francisco Santos, Karin Thorburn, Charles Wang (AAA discussant), Jingjing Wang, Maria Wieczynska (IAS discussant), two anonymous reviewers, and workshop participants at Norwegian School of Economics (NHH), University of California at Berkeley (Haas doctoral workshop), City University of Hong Kong, 2015 Financial Accounting and Reporting Section (FARS) Midyear Meeting, 2015 International Accounting Section (IAS) Midyear Meeting, Rotman School of Management (and Rotman doctoral workshop participants), University of Auckland, Tsinghua University, Peking University, University of Kentucky, 2015 Annual Congress of the European Accounting Association, McMaster Accounting Research Conference, Santa Clara University, 2015 CAAA Annual Meeting, 2015 MIT/Asia, 2015 AAA Annual Meeting, and the NFA 2015 Conference for valuable comments. Hope gratefully acknowledges the financial support of the Deloitte Professorship.

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Authors and Affiliations

  1. Rotman School of Management, University of Toronto, Toronto, Canada

    Ole-Kristian Hope & Wuyang Zhao

  2. BI Norwegian School of Management, Oslo, Norway

    Ole-Kristian Hope

  3. Department of Accounting and Management Control, HEC Paris, Paris, France

    Han Wu

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  1. Ole-Kristian Hope
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Correspondence to Ole-Kristian Hope.

Appendices

Appendix 1

Table 10 Variable definitions
Full size table

Appendix 2

1.1 Definition of outside blockholders

We define an outside blockholder as a shareholder holding at least 5% shares who is not (or is not the representative of) the chairman of the board, CEO, CFO, or other executive of the firm, or a relative of a person in these positions. We identify the outside blockholders through manually searching in CSMAR’s director datasets to exclude the large shareholders who are closely related to the managers. Below we provide three examples of this manual collection. The three selected firms are the first three in our dataset based on stock code.

ShenFaZhan A (code: 000001): In our treatment definition year (2004), ShenFaZhan A has one shareholder holding more than 5%: Newbridge Asia holding 17.89%. According to CSMAR, there are no ShenFaZhan executives or their relatives holding positions in Newbridge. Newbridge is thus counted as an outside blockholder, instead of a manager-related shareholder.

WanKe A (code: 000002): In 2004, WanKe A has one shareholder holding more than 5%: HuaRun Group holding 12.89%. According to CSMAR, there are no WanKe executives or their relatives holding positions in HuaRun. HuaRun is thus counted as an outside blockholder.

GuoNong Technology (code: 000004): In 2004, GuoNong Technology has two shareholders holding more than 5%: ShenZhen ZhongNongDa Technology and Investment holding 37.94% and ZhaoShangJu Real Estate holding 7.41%. Zetian Fu, chairman of GuoNong Technology, holds a position in ZhongNongDa Technology. ZhongNongDa is thus counted as a manger-related shareholder, instead of an outside blockholder. There are no GuoNong executives or their relatives holding positions in ZhaoShangJu. ZhaoShangJu is thus counted as an outside blockholder.

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Hope, OK., Wu, H. & Zhao, W. Blockholder exit threats in the presence of private benefits of control. Rev Account Stud 22, 873–902 (2017). https://doi.org/10.1007/s11142-017-9394-2

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