Proposition Building, Complementarities and Substitution Effects

The previous section provided a review of the causal conditions that affect principal- principal conflicts. Most of the empirical literature is however based on methods that isolate the effect of each determinant. Theory, on the other hand, is increasingly evolving towards a configurational understanding of corporate governance. Not only is the efficiency of governance structures contingent upon other elements such as the ownership structure and

firm size, but individual practices are often only functioning when part of a bundle of complementary practices. Complementarities can also create asymmetry when a condition produces opposite effects depending on the circumstances. In addition, there may be redundancy if two conditions have an equivalent function, which can result in potential substitution effects.

Misangyi and Acharya (2014) explain that the argument that corporate governance practices are substitutes rests on the idea that they are chosen according to efficiency and costs considerations and that they balance each other to maintain an “equilibrium organization of the firm” (Demsetz, 1983: 384). For instance, to resolve principal-agent problems, more incentive compensation is deemed necessary if the level of monitoring is weaker (Beatty & Zajac, 1994). Similarly, internal monitoring is assumed to be able to palliate to the absence of external discipline provided by an active market for corporate control. Another stream of literature has suggested that corporate governance instead consists of coherent systems of synergistic practices that are best understood as bundles (Aguilera et al., 2008; Rediker & Seth, 1995). This idea of mutually reinforcing conditions has mostly been studied in the international context, comparing how firm level practices adapt to create complementarities with national level institutions (Aguilera et al., 2012). For instance, external control mechanisms and dispersed ownership are only possible in jurisdictions that enforce strong shareholders’ rights. Yet, complementarities do not necessarily entail rigid adherence to an archetype, but can be reduced to two or three practices that create synergies within the bundle (Garcia-Castro et al., 2013). Finally, while substitution and complementarity have typically been opposed as competing views in the literature, recent contributions in this field show that these effects are not mutually exclusive. Indeed, Misangyi and Acharya (2014: 1701) propose that “the effectiveness of the governance bundle involves the simultaneity of substitution and complementarity among the various monitoring mechanisms”. Garcia- Castro et al. (2013: 309) also find empirical evidence supporting the idea that the presence of any two mechanisms that belong to the same coherent bundle is sufficient, as opposed to the whole bundle itself. They argue that this “functional equivalence across bundles of CG practices […] grants firms agency on which of the practices to implement”.

Beyond these expected complementarities and substitutions between corporate governance practices, interactions may also occur among other firm level conditions. Certain incentives or governance bundles may have an effect only in certain types of firms (Aguilera & Jackson, 2003). As explained above, two conditions are especially relevant regarding the type of firms in the expropriation problem: firm size and private VS state control. For instance, the monitoring role of the board is expected to be more salient in large firms. This contingency is not uniform. For example, the argument that a large share of ownership by the largest shareholder reduces tunneling incentives applies to both large and small firms.

Following these insights, most of the guiding propositions offered below are based on interaction effects that involve the various determinants discussed in the previous section. It should be noted that given its exploratory nature, the investigation is mostly interested in effects that might emerge in an inductive manner and that can contribute to understanding how the ownership structure, corporate governance practices and state control impact tunneling behavior. The propositions are mainly used to guide the empirical analysis and provide an explicit starting point to relate the findings to the existing literature.

The first two propositions concern the incentives and mechanisms that contribute to tunneling behavior. Firstly, a low proportion of shares by the largest shareholder has been identified as a key element contributing to the misalignment of incentives between the many principals (Claessens et al., 2002; La Porta et al., 2002). Secondly, a high leverage stands out as an important mechanism through which firms draw resources to be tunneled (Jiang et al., 2010; Wang & Xiao, 2011; Yeh et al., 2012). Thirdly, a low floating ratio has also been identified as offering an important incentive for controlling shareholders to find alternative ways to obtain cash flow that can hardly materialize through stock value appreciation (Chen et al., 2009; Yang et al., 2011). However, given that state-owned enterprises have strict restrictions on share trading, the impact of the floating ratio is expected to mainly concern private firms. In the case of SOEs, on top of the two first conditions that still apply (a low proportion of shares by the largest shareholder and a high leverage), there may be an additional interaction between state control and firm size. This follows Capalbo et al.’s (2014) finding that smaller SOEs are more prone to manipulate earnings and builds on Jiang

et al.’s (2010) and Cheung et al.’s (2010) finding that local SOEs, which are much smaller (McMillan & Evans, 2015), are more susceptible to engage into tunneling behavior.

Proposition 1a: The largest shareholder in private firms will embark on tunneling if three conditions co-exist: high leverage, low floating ratio, and them holding a relatively low share of equity.

Proposition 1b: In state-controlled firms a relatively low share of equity in the hands of the largest shareholder in combination with high leverage and small firm size leads to tunneling.

In addition to the incentives discussed above, three propositions concern the commitment to best practices in corporate governance. The insights from Chen et al. (2011) suggest that firm-level corporate practices can keep tunneling behavior in check in the event that the controlling shareholder has the incentives and ability to engage in it. An independent board (Liu & Lu, 2007), proactive disclosure (Yuan et al., 2009) and rigorous internal audit (Xie et al., 2003) can contribute to preventing expropriation. The recent literature suggesting that corporate governance practices may be simultaneously complementary and substitutive (Garcia-Castro et al., 2013) warrants the formulation of the following proposition:

Proposition 2: Provided that there are sufficient incentives for tunneling, the lack of at least two out of these three governance mechanisms leads to tunneling behavior: board independence, proactive disclosure, and independent internal auditing.

Yet, this proposition does not encompass the extent of the causal complexity at play in the principal-principal problem. An important factor lies in the role of large minority shareholders, but past literature suggests that this condition may be marked by causal asymmetry. The inclination of such investors in Asia to collude in the diversion of cash flow, as opposed to those in Europe, may trickle from a lack of disclosure (Faccio et al., 2001). Disclosure may therefore be a crucial complementary element with the presence or large minority shareholders if these outsiders are to effectively monitor insiders.

Proposition 3: Provided that there are sufficient incentives for tunneling (see P1) and that there are large minority shareholders, a lack of proactive disclosure is a crucial element contributing to tunneling.

Secondly, past literature is equivocal on the role of independent directors. As suggested in

proposition 2, a conjunction with other corporate governance practices may instill more vigilance in safeguarding the interests of minority investors (Aguilera et al., 2008). Yet, especially in the Chinese context, boards may be used as rent generating mechanisms to reward friends of the regime (Su et al., 2008). It is expected that such rent seeking motives are mostly salient in state controlled firms, where nominations are used as an instrument to entrench the Party Nomenklatura (Brødsgaard, 2012).

Proposition 4: In state controlled firms, a high proportion of independent directors contributes to tunneling.

In what follows, a configurational analysis on a large sample of Chinese listed firms explores the causal conditions and interactions that emerge in the bundles of conditions that lead to tunneling behavior and those that avert it. The results are discussed in light of the preceding theoretically grounded propositions.