Connected Party Transaction Stephen Yanleung Cheung School of

Connected Party Transaction Stephen Yan-leung Cheung School of Business Hong Kong Baptist University Hong Kong

Contents n n n Corporate governance Research in Hong Kong Corporate governance Research in China Policy work

Corporate Governance in Hong Kong- Introduction “. . . China Logistics Group (00217) to confess that millions of dollars has gone missing from its coffers. . The bulk of the cash is suspected to have vanished across the border. . A HK$ 200 million deposit paid out for the acquisition of Shanghai Pudong CNCC Logistics Development was missing. . . while the money left China logistics, it was allegedly never received by the vendor. ” South China Morning Post, 18 September 2002. Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

Corporate Governance - Introduction Companies with concentrated ownership: n Extract cash by selling assets, goods, or services n Obtain loans on preferential terms n Assets transfer n Dilute the minority shareholders’ interests A connected transaction is a) Any transaction between a listed issuer or any of its subsidiaries and a connected person; and b) An acquisition or realisation by a listed issuer or any of its subsidiaries of an interest in a company, a substantial shareholder of the listed acquiring or realising issuer or any of its subsidiaries of the listed issuer or any of its subsidiaries Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

Types of Connected Transactions 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) Asset acquisition Asset sales Equity sales Trading relationships Cash payments Cash receipts Subsidiary relationships Takeover & joint-ventures J V stake acquisition J V stake sales Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

Corporate Governance - Objectives 1) 2) 3) What are the valuation effects of different types of connected transactions? What are the characteristics of firms more likely to expropriate? Does the market anticipate the expropriation by firms? Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

Observations 1) 2) 3) 2 times more assets acquisition than asset sales; cash from listed companies to its controlling owners 3. 5 times more in providing cash assistance to third parties as opposed to receiving assistance Terms are unfavorable (acquiring at a premium or selling at a discount) for most deals when information are available Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

Results n Short term – Average of -3. 4% during a period of 10 days after announcement Sales of equity stake -11. 8% n Long term – Average of -12. 6% during a period of 12 months after announcement Sales of assets -21. 9% Sales of assets -6. 4% Trading relationships -21. 8% Acquiring of assets -7. 5% Cash payment -18. 7% Trading relationships -7. 5% Takeover & JV -29. 8% Selling JV -6. 1% Selling JV -17. 2% Cash payment -2. 5% Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

All Connected Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

Returns Are n n n Negatively related to percentage ownerships by the main shareholders Negatively related to proxies for information disclosure ¨ Value of transaction ¨ Independent financial advisor ¨ Big 5 as auditing firm Likelihood of undertaking connected transactions is higher ¨ Ultimate owners can be traced to mainland China Likelihood of not disclosing the value of the deal and likelihood of violating the listing rules are higher for ¨ Mainland China ownership ¨ Concentrated ownership Variables of Corporate governance do not have any impact ¨ Audit committee ¨ Number of independent non-executive directors ¨ CEO duality Cheung, Y. L. , P. R. Rau, and A. Stouraitis. 2006. Tunneling, Propping and Expropriation Evidence from Connected Party Transactions in Hong Kong. Journal of Financial Economics, 82, 363 -386

Corporate Governance- Hong Kong n The Evidence ¨ Market reacted very negatively by the listed firms when they announced different types of related party transactions n The Question ¨ What is the process through which controlling shareholders extract resources from publicly listed firms they control? Cheung, Y. L. , Y. Qi, P. R. Rau, and A. Stouraitis. 2008 Buy High, Sell Low: How Listed Firms Price Asset Transfers in Related Party Transactions. Journal of Banking and Finance, forthcoming

Fair Value n n Asset acquisitions Asset sales between n n Related parties Arms’ length (non related parties) Fair Value Estimation n Problems ¨ Not publicly listed firms ¨ No observable market value n “Fair” value is a function of accounting book value and past operating earnings of these assets n Controlling shareholders appear to benefit directly at the expense of publicly listed firms by selling (acquiring) assets to (from) them at high (low) market price Cheung, Y. L. , Y. Qi, P. R. Rau, and A. Stouraitis. 2008 Buy High, Sell Low: How Listed Firms Price Asset Transfers in Related Party Transactions Journal of Banking and Finance, forthcoming

Do Corporate Governance Practices Matter? n Corporate governance variables have limited impact on the pricing of the deal. Only firm with an audit committee on the board and firms with large number of analysts following conclude related party transaction at a more favorable price Cheung, Y. L. , Y. Qi, P. R. Rau, and A. Stouraitis. 2008 Buy High, Sell Low: How Listed Firms Price Asset Transfers in Related Party Transactions Journal of Banking and Finance, forthcoming

Corporate Governance -China This paper examines a sample of 292 related party transactions between Chinese publicly listed firms and their controlling shareholders obtained from filings submitted to stock exchange authorities during 2001– 2002. n characteristics of firms that conduct different types of related party transactions. On balance, there seems to be more tunneling than propping up in our sample. n significant differences in the information disclosure between tunneling and propping up related party transactions. n majority of firms in our sample experience a reduction in firm value at the announcement of related party transactions. n Our robustness tests show that this reduction in value is not present in similar arms' length transactions. Yan-Leung Cheung, Lihua Jing, Tong Lu, Raghavendra Rau, , Aris Stouraitis (2009) ”Tunneling and propping up: An analysis of related party transactions by Chinese listed companies”, Pacific Basin Finance Journal

Valuation effects of different types of related party transactions in China 2001 -2002 CAR [-1, +1]% CAR [-2, +2]% CAR [-2, +5]% Type of ownership All types of state ownership (N=196) Mean Median − 0. 3 (0. 204) − 0. 5 (0. 020)** − 0. 6(0. 018)** − 0. 5 (0. 004)*** − 0. 6 (0. 028)** − 0. 7 (0. 011)** Central Govt state ownership (N=39) Mean Median − 0. 1 (0. 799) − 0. 2 (0. 582) -0. 3(0. 569) -0. 2(0. 490) -0. 2(0. 772) 0. 1(0. 917) Local Govet state ownership (N=161) Mean Median − 0. 3 (0. 181) − 0. 5 (0. 050)** -0. 3(0. 257) -0. 3(0. 053)* -0. 5(0. 263) -0. 7(0. 026)** Private ownership (N=79) Mean Median 0. 5 (0. 089)* 0. 2 (0. 068)* 2. 4(0. 219) 0. 1(0. 098)* 1. 7(0. 394) 0. 1(0. 786) 0. 8 (0. 304) 0. 1 (0. 443) 2. 8(0. 059)* 2. 0(0. 029)** 3. 4(0. 300) 1. 9(0. 132) Foreign shareholder Mean Hshare ADR (N=15) Median

Implications: Two regulatory implications for emerging markets. n We highlight the importance of foreign investors and cross-listing in mitigating the expropriation of minority shareholders. These have important implications for allowing foreign investors to participate in emerging markets and in strengthening accounting standards in these markets. n Our results suggest that higher standards of disclosure with respect to the transaction itself also help mitigate the expropriation of minority shareholders through related party transactions. Yan-Leung Cheung, Lihua Jing, Tong Lu, Raghavendra Rau, , Aris Stouraitis (2009) ”Tunneling and propping up: An analysis of related party transactions by Chinese listed companies”, Pacific Basin Finance Journal

Corporate Governance- China Do minority shareholders in state-owned publicly listed firms benefit from the presence of government shareholders and politically connected directors? The helping hand hypothesis. Prior research has shown that shareholders in firms with close ties to governments gain from political connections- borrow on preferential terms from state-owned banks The grabbing hand hypothesis. Corrupt government bureaucrats enrich themselves by misappropriating funds from these firms or by demanding lavish perks. The expropriation may be facilitated by the presence of politically connected directors on company boards. YAN-LEUNG CHEUNG , RAGHAVENDRA RAU and ARIS STOURAITIS Helping Hand or Grabbing Hand? Central vs. Local Government Shareholders in Chinese Listed Firms Review of Finance (2010) 14: 669– 694

Corporate Governance- China It is difficult to compute the “fair” value of assets changing hands in China, we measure the transfer of value to (from) the listed firm by the abnormal stock returns at the announcement times the firm’s market capitalization over the announced size of the deal. We find • Helping hand hypothesis, related party transactions by firms with central government connections appear to benefit the minority shareholders of the listed firms. • Grabbing hand hypothesis, for firms connected to local governments- transfer of wealth from the minority shareholders to their state-owned controlling shareholders. • What is significant is the type of government shareholder (local or central) and the political affiliation of the firm’s directors. YAN-LEUNG CHEUNG , RAGHAVENDRA RAU and ARIS STOURAITIS Helping Hand or Grabbing Hand? Central vs. Local Government Shareholders in Chinese Listed Firms Review of Finance (2010) 14: 669– 694

Corporate Governance- China Who benefits from the expropriation? • are not related to SOE or provincial economic performance (most of the expropriation is concentrated in China’s richest provinces) and therefore cannot be attributed to a social role motive • are concentrated in provinces where local government bureaucrats are less likely to be prosecuted for misappropriation of state funds, suggesting that they are likely related to corruption. YAN-LEUNG CHEUNG , RAGHAVENDRA RAU and ARIS STOURAITIS Helping Hand or Grabbing Hand? Central vs. Local Government Shareholders in Chinese Listed Firms Review of Finance (2010) 14: 669– 694

Do Corporate Governance Practices Matter? An article in the Wall Street Journal titled “Even good insider deals raise doubts” “… Such related-party transactions raise questions about whether corporate insiders are fully focused on the interests of shareholders, experts say. The deals, no matter how small, can create the impression that insider is using company assets for personal benefit, and that the company is getting the short end of the stick. …”

Discussion n The quality of independent non-executive directors n Information disclosure n Regulatory framework

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