Table 12 Floating complementarities
5 DISCUSSION AND CONCLUSION
One of the main objectives of this study is to bridge new insights from the literature on complementarities and substitution effects in firm level corporate governance practices and the increasingly large body of empirical work on principal-principal problems. A new methodological approach, the fuzzy set QCA, is used to study the issue of tunneling behavior from a configurational perspective (Fiss, 2007). This set theoretic method allows to treat governance structures as bundles and to contextualize practices in relation to the surrounding causal conditions (Aguilera et al., 2008). In the field of corporate governance, this method is increasingly used in comparative corporate governance and in studies focusing on principal-agent problems (Garcia-Castro et al., 2013). Its main advantage is to emphasize the interdependencies among conditions instead of looking at the additive effects of practices
taken in silo. As Misangyi and Acharya (2014: 1703) put it, “to truly understand governance effectiveness, we must stop thinking about the mechanisms in isolation”.
This article shows that configurational analysis is particularly well suited to examine the controlling shareholder expropriation problem because it can unravel the causal complexity of the phenomenon and it recognizes the diversity of causal paths that can lead to the outcome. Specifically, the fsQCA method was used to study data from 1337 Chinese listed firms in 2005 to find the complementarities and substitutions that explain the presence and absence of tunneling in the form of inter-firm loans. Tunneling behavior depends on a number of conditions involving the ownership structure, the commitment to best practices of corporate governance, whether a firm is private or state-owned and on key financial factors, namely firm size and leverage. By examining the interaction effects and the causal asymmetry that shape principal-principal problems, the empirical study lays a number of conceptual building blocks that offer a starting point to reconcile the many equivocal results that have beset the literature. The findings raise a number of interesting questions.
The first findings concern the incentives and mechanisms that drive tunneling behavior. Firstly, the results unambiguously show that the main effect of the proportion of shares of the largest shareholder rests in the income rights, which determine the alignment or misalignment of interests with minority investors. This confirms that a relatively low ownership concentration at the very top represents the main incentive for tunneling (Claessens et al., 2002; La Porta et al., 2002). Secondly, one of the two main mechanisms employed in tunneling that emerge from the study is that insiders obtain funds by contracting debt from banks and subsequently tunnel this money to related parties through inter-firm loans. Indeed, a high leverage is found to be a key condition leading to tunneling, which is in line with the results of other studies (Jiang et al., 2010; Wang & Xiao, 2011; Yeh et al., 2012). Thirdly, the other mechanism identified lies in the vulnerability of smaller firms. Previous studies had shown that the more there is tunneling through inter-firm loans, the larger is the proportion that can be traced to a parent company (Jiang et al., 2010). That small firm size appears as a key condition for tunneling suggests that these firms are more easily subject to expropriation by larger corporate entities. Small investors are thus more vulnerable to tunneling in small firms, which confirms the results of Wang and Xiao (2011).
Insights from the studies of Jiang et al. (2010) and Cheung et al. (2010) about malpractice in local SOEs had suggested that this effect would predominantly apply to state controlled firms, but the present findings show that it also applies to private firms. The fact that the results on the effect of firm size run counter to those of Huyghebaert and Wang (2012) and Yeh et al. (2012) might be explained by the fact that large firms may also be involved in related party loans, but that their position may be less detrimental to small shareholders because larger firms may act as transaction hubs on the receiving end of the inter-firm loans. This specific relation would benefit from additional research. Finally, the analysis shows a three-way partly substitutive and partly complementary interaction among these three conditions. Nearly all configurations that display at least two conditions (small firm, high leverage, low shareholding by the largest shareholder) lead to tunneling behavior. This interaction is fully symmetric since nearly every configuration that displays at least two of the opposite conditions (large firm, low leverage, high shareholding by the largest shareholder) lead to the absence of tunneling.
The second group of findings concerns the role of corporate governance practices. The most salient effect occurs when tunneling incentives and mechanisms are in place. Then, the absence of a commitment to governance plays an enabling role towards tunneling. The only systematic and symmetric effect concerns proactive disclosure. Its absence is a causal condition in every configuration leading to tunneling and its presence contributes to a majority of configurations that do not produce tunneling, especially those that involve small firms or small minority shareholders. This evidence validates empirically the preference of outsiders for strong disclosure practices reported by Liu (2006b). The absence of disclosure alone is not sufficient to act on tunneling incentives. It must be complemented by the absence of at least one other governance practice. In configurations that do not rely on large minority investors, the complementary condition may rest in either the absence of rigorous internal audit or the absence of board independence. This lends some support to the idea of a complementary monitoring role among corporate governance practices (Aguilera et al., 2008; Cheng & Courtenay, 2006). In configurations that do rely on large minority shareholders, board independence exhibits an asymmetric effect that will be further discussed below. Yet, in this context, a low floating ratio appears to offer an additional possible complementary condition with absent disclosure. This lends support to the claim
that the floating ratio may be a valid measure of governance (Wang & Xu, 2004), but its effect is mostly bounded to configurations that rely on large minority investors. In sum, the results show that, in the presence of tunneling incentives, while the absence of commitment to best corporate governance practices plays an enabling role for expropriation, a strong commitment to governance cannot effectively deter it. Furthermore, in the absence of tunneling incentives, the monitoring role of mutually reinforcing corporate governance practices is not relevant.
The third main finding concerns the specific role played by independent directors in principal-principal problems. The effect of board independence is one of the most disputed elements in the literature and has produced unsettling and equivocal results in past empirical work. In turn, board independence has been found to deter tunneling behavior (Liu, 2006b; Liu & Lu, 2007), to contribute to it (Su et al., 2008) and to be merely symbolic or insignificant (Chen et al., 2011; Huyghebaert & Wang, 2012; Peng, 2004). The present study provides very interesting results that shed light on the interactions that drive the asymmetric effect of board independence. Most importantly, when tunneling incentives and mechanisms are in place, board independence is detrimental when combined with state control or large minority investors. In the case of SOEs, this finding lends support to the idea that board nominations are used by state agencies as a rent generating mechanism to reward friends of the regime and ensure the prioritization of political objectives over the wealth maximization of shareholders (for a discussion on the Party Nomenklatura system, see Brødsgaard, 2012). In the case of firms with large minority shareholders, independent directors are instrumental to the alignment of interests among the most prominent principals and contribute to tunneling behavior. The results obtained by Faccio et al. (2001) to the effect that the presence of large minority shareholders in Asia do not contribute to effective monitoring like those in Europe but rather engage in collusion with the controlling shareholder are contingent upon a large proportion of independent directors on the board. Otherwise, in every configuration leading to tunneling that involves neither state control nor large minority investors, the reliance on absent board independence confirms the monitoring role independent directors and that the controlling owner of private firms that have relatively low shareholding will prefer to set up an insider-dominated board if they are to engage in tunneling. Finally, the results show an additional symmetric complementarity between board independence and the
floating ratio. The alignment of the presence or absence of these two conditions contributes to a positive outcome. In other words, an insider dominated board plays an effective monitoring role in firms that are less exposed to the capital markets while an outsider- dominated board plays an effective monitoring role in firms that are more exposed to the capital markets. Additional research would be desirable to provide a more substantive explanation about this interaction.
Taken together, these findings contribute to the corporate governance literature in several ways12 by identifying firm-level interdependencies among corporate governance practices,
including asymmetric effects and functional equivalents. The corporate governance problem analyzed in this chapter, the controlling shareholder expropriation problem through related- party transactions, is the most salient problem in Asia and China. The large number of studies on the issue provide conflicting and equivocal results mainly derived from statistical methods and fail to identify a consensual set of determinants of tunneling behavior (Chen et al., 2009; Huyghebaert & Wang, 2012; Jiang et al., 2010; Wang & Xiao, 2011). In this chapter, the use of a configurational method has allowed to consolidate the literature by identify two main and distinct components in the problem. Three drivers of tunneling behavior provide the incentives and mechanisms for firms to engage in related party loans. Then, several features of monitoring affect the ability of controlling shareholders to achieve expropriation. While the drivers are stable across configurations, the effective set of monitoring practices depends on the ownership structure. Most importantly, the findings show that within each component (drivers, monitoring), causal conditions may at the same time be complements and substitutes. This is a direct extension of the work of Garcia-Castro et al. (2013) and Misangyi and Acharya (2014) on principal-agent problems.
The study clarifies, in the context of ill-functioning legal institutions and weak property rights, under which types of ownership structure a lack of commitment to best corporate governance practices enables a misalignment of interests between controlling shareholders and minority investors. Because of its socialist past, China carries a tradition of government involvement and of weak protection of formal property rights. The findings reported above
show that the heritage of the common property regime still weights on corporate governance structures in listed firms. The deployment of the state agents through board directorships in SOEs hurts the interests of small shareholders. Finally, the findings support the view of Filatotchev and Allock (2010) and Garcia-Castro et al. (2013) that, given the causal complexity of corporate governance embodied in complementarities, substitution effects and asymmetry, a soft law approach of “comply or explain” might be better suited as one size doesn’t fit all (Arcot, Bruno, & Faure-Grimaud, 2010; MacNeil & Li, 2006). Yet, the prominent importance of disclosure in the results suggests that such an approach might be contingent upon the actors’ access to reliable information to be empowered to conduct effective monitoring. To conclude, this article shows that coherent bundles of governance mechanisms that could effectively prevent tunneling even in the presence of incentives are still to be designed.