1 INTRODUCTION

The field of corporate governance has long had a narrow focus on principal-agent relationships between owners and managers (Daily et al., 2003; Rubach & Sebora, 1998; Shleifer & Vishny, 1997), mainly paying attention to the alignment of executive incentives

through compensation packages, the establishment of internal monitoring by optimizing board composition and the nurturing of external control through healthy markets for hostile takeovers (Blair, 1995; Fama & Jensen, 1983; Rajan & Zingales, 1998; Walsh & Seward, 1990). Yet, instead of originating from principal-agent problems, the biggest corporate governance concerns in many countries come from principal to principal relationships (Faccio et al., 2001; Young, Peng, Ahlstrom, Bruton, & Jiang, 2008). In markets characterized by high ownership concentration, the disparity of interests between the many owners is more salient. In this sense, it cannot be assumed that shareholders form a homogenous group. The difference to principal agent relations is a follows. While agents, i.e. managers, are controlled by their principals, i.e. owners which have an interest in safeguarding effective allocation of resources and investment into productive activities which promise high future returns, in principal-principal relations one needs to distinguish between insider and outsiders. At the heart of this phenomenon, the collusion of interests between at least one principal and the agents may cause problems, enabling the owner to reap private benefits of control beyond his legitimate cash flow rights. Indeed, the presence of a large controlling shareholder typically involves direct control over high management, effectively ensuring the alignment of incentives between the dominant principal and the agent, which are together characterized as ‘insiders’. The other principals are mostly small investors better characterized as ‘outsiders’ that keep minority shares and expect more moderate yet fair and proportionate financial returns, mostly in the form of dividends. The interaction between these groups of owners determines the allocation of assets and cash flows within the firm. The structure of ownership is therefore paramount to understanding the principal-principal relationship. In other words, modeling principals as one homogenous group or assuming divergent interests between all principals and agents misses the actual decision making and cash flow appropriation.

Conventionally, the relationship between the multiple principals is organized in contracts set to align their interests, including ways to resolve conflicts. The contracts usually cover liabilities, transfers of assets, organizational forms that separate management and ownership and the allocation of residual benefits. Yet, within the contractual relationship, a misalignment remains between the interests of minority investors and the largest shareholder. Because of the discrepancy between its decision making rights and income

rights, the largest shareholder can use his dominant position to appropriate a disproportionate share of the firm’s residual returns (Claessens et al., 2000). In other words, the generation of private benefits of control becomes more desirable than the redistribution of cash flows according to income rights when insiders hold nearly full control of the firm (Shleifer & Vishny, 1997). This diversion of cash flow has been referred to as the controlling shareholder expropriation problem (Chen et al., 2011). The most common form of such expropriation is called tunneling (Friedman, Johnson, & Mitton, 2003), which consists of the transfer of assets within a corporate network through loans or sales to other entities controlled by the same owner. Because they involve parties that are connected through ownership ties or possibly by kin, these dealings are referred to as related party transactions. Tunneling has been identified as the greatest corporate governance challenge in Asia generally (Faccio et al., 2001; Johnson et al., 2000; OECD, 2009a, 2011a, 2011b) and in China specifically (Young et al., 2008).

The literature on investor-protection (La Porta et al., 2000) suggests that the safeguard of shareholders’ interests rests on contracts supported by laws and regulation. Djankov, La Porta, Lopez-De-Silanes and Shleifer’s (2008) anti-self-dealing index is noteworthy to this end. The index assessed for 72 countries as of 2003 the legal framework that underpins private enforcement mechanisms before and after a related party transaction. Its components, divided into ex-ante and ex-post control indicators, reference requirements for disclosure, independent review, derivative lawsuits8 _{and civil liabilities as well as measures of public}

enforcement, fines and prison terms for contraveners. China appears in the top 10 of countries with the best score for anti-self-dealing regulations. Yet, it scores zero in the public enforcement index (Djankov et al., 2008). This underscores the idea that a formal approach only works in the context of strong legal institutions that enforce binding contracts.

Such contractual and legal measures may therefore not be effective in markets with ill- functioning institutions like China, which carries a socialist heritage where there is no tradition for protecting individual property rights, entitlements and obligations. In this vein, the experimentalist school attributes the Chinese successes to competitive SOEs, collectively

owned township and village enterprises (TVEs) and ambiguous agricultural land property (Sachs & Woo, 2001).From this perspective, the relation to ownership rather resembles a system of jointly owned resources or common property regimes (see common-pool resources, Elinor Ostrom, 1990), inherited from the past where a clan or a local community functioned as collective owner. In this system, resources are owned by the village or county collectively and no clear property rights based on contracts are guaranteed by national legislation. As has been shown in the literature on the ‘commons’, this may create some conflicts of free riding and overgrazing. The over-use of resources by individuals in the short run at the expense of long term availability becomes symptomatic and may lead to underinvestment. In this “non-contractual” context, decision-making power and usage of cash flow is constantly negotiated and recombined among principals (Stark, 2001). In China, this view has been especially dominant during the rise of township and village enterprises (Krug & Hendrischke, 2012), and is still relevant in the ministries that administer a substantial proportion of listed firms and regulate all of them. This heritage has two main consequences. Firstly, the contracts are often not binding. Secondly, firm ownership is still frequently collectively held in the hands of the state. In other words, principal-principal relationships in China are not only about ownership contracts, but also about the involvement of the state and a weak legal system. The study of tunneling and expropriation needs to account for this, especially in the case of state owned enterprises (SOEs). Besides the aforementioned incentives to harvest the private benefits of control, governance in state- owned enterprises may also be tainted by politically driven constraints and incentives that serve the political intentions of the state rather than the commercial interests of the firm. The view taken here is that the Chinese case does not fit any ideal type, that it lies somewhere between the contractualist approach and the heritage of jointly owned resources.

The aim of the present article is to shed light on the conditions driving tunneling behavior in the context of weak private ownership rights. It is not necessary to further investigate whether cash flow is redirected to serve other purposes, such as political aims of cadres or private economic interests of shareholders. It is rather the identification of conditions which set incentives, offer a suitable mechanism, and possible constraints which clarifies the interaction leading to the diversion of cash flow. Specifically, the main research question is the following: under which conditions does the controlling shareholder have the incentive

and the ability to expropriate cash flow from the firm. The model developed here posits that principal-principal problems depend on four types of conditions: ownership structure, state control, corporate governance practices, and financial factors including firm size and leverage. Embedded in this question, because of the recent heritage of jointly owned resources, is the additional objective of assessing whether the conditions producing tunneling in SOEs are different from those in private firms. Finally, this study accounts for the possibility that tunneling may be an asymmetric problem. In other words the conditions that lead to expropriation are not necessarily expected to be the opposite of the conditions that deter it. Do owners face disincentives or lack the appropriate tools for tunneling? Can corporate governance practices help prevent such attempts? Accordingly, two separate analyses are used to assess the conditions under which tunneling behavior is present, and those under which it is absent.

The empirical study uses a set theoretic method (Fiss, 2007, 2011) operationalized in the fsQCA software (Ragin et al., 2006). Such a configurational analysis has been identified as a particularly well suited method to study the causal complexity of corporate governance structures (Filatotchev & Allcock, 2010; Short et al., 2008). Set theory, using Boolean logic, is especially useful in the study of equifinality, which involves multiple causal paths to a single outcome. It also allows analyzing causal asymmetry when specific governance practices are instrumental to both the presence and the absence of an outcome depending on the interaction with other conditions, and whether particular conditions act as functional equivalents involved in neutral permutations in their causal relation to the expropriation problem. The outcome variable that measures the extent of the tunneling problem is based on a measure of related party loans, which represents money that the firm transfers to another related firm through the use of inter-firm loans. The item “other receivables”, disclosed by Chinese listed firms until 2005 in their annual report, contains inter-firm loans and has been identified as a valid measure of related party loans and a good proxy for tunneling (Jiang et al., 2005, 2010). It has been demonstrated that the larger these other receivables are, the larger the share that can be directly traced to a related party or parent company. While using inter-firm loans does not represent malpractice in itself, preferential loans freeze cash flow that could otherwise be put to productive use. In addition, top executives of 10 firms that

had failed to recover such loans to related parties in 2006 were arrested by the authorities (Jiang et al., 2010).

The dataset contains 1337 listed Chinese firms for the year 2005, representing 99% of the population. While the market has evolved since 2005, related party transactions are still considered the biggest corporate governance problem in Asia, including in China (OECD, 2009a). Ironically, the emphasis put on disclosure has also pushed firms to better hide certain transactions, making measures of tunneling increasingly blur. 2005 was therefore chosen because it is the most recent year for which the “other receivables” were disclosed, and because other studies on the same time period and population allow to compare the results of the configuration analysis with the existing empirical literature based on statistical methods. This offers the opportunity to improve existing conceptual building blocks, especially regarding the interactions between the determinants.

The results offer a number of interesting findings. Firstly, a low proportion of shares by the largest shareholder produces a misalignment of interests with those of minority investors and provides incentives for tunneling. High firm indebtedness (leverage) is identified as a key causal condition in most configurations that lead to tunneling, and thus appears to be used as a mechanism to draw monetary resources to be tunneled to related parties. These two conditions, along with small firm size, are involved in a three way interaction in which the presence of only two out of three conditions is sufficient to create the tunneling incentives and mechanisms. These findings are symmetric since a small controlling shareholder, a low leverage and a large firm size are identified as important causal conditions leading to low tunneling. Secondly, the absence of proactive disclosure is a quasi-necessary causal condition to enable tunneling, but it must be complemented by a lack of rigorous audit or a lack of board independence. Only in configurations that rely on large minority investors, it can also be complemented by a low floating ratio. This finding is not symmetric in that, in the absence of tunneling incentives, strong commitment to best corporate governance practices matters very little. Thirdly, provided that there are sufficient incentives for tunneling, board independence is detrimental if combined with state control or large minority shareholders. In such contexts, the results suggest that directorships become a rent generating mechanism that plays an enabling role for collusion towards tunneling behavior.

This research has two main contributions. Firstly, it offers an analysis of the principal- principal problem in the context of weak ownership rights and limited enforceable contracting. The empirical study is helpful to understand under which types of ownership structures, regarding both state ownership and shareholding concentration, a commitment to best practices of corporate governance can effectively align the interests of multiple principals. This is relevant to understand the contractual relationships and governance structures preferred by small investors in any transition economy not only China. Secondly, by identifying the specific configurations that enable tunneling behavior and the ones that inhibit it, the research furthers our understanding of the causal complexity and asymmetry at play in the principal-principal problem. Some equivocal findings from the literature on corporate governance, which are detailed further below, are reconciled by showing that the complementarities and substitution effects through which conditions contribute to the causal relation are not mutually exclusive. This underscores the importance of theorizing corporate governance practices as bundles of interdependent conditions. Such subtle interactions cannot be easily unearthed with traditional statistical methods that rely on marginal and additive effects.

The remainder of this article is divided as follows. Section two offers a literature review of the tunneling problem and the causal conditions and builds propositions used to guide the empirical study. Section three presents the set theoretic method employed in the empirical study. Section four contains and explains the empirical results. Section five discusses the findings and concludes on limitations and implications for future research.