Ownership structure, corporate governance, and fraud:Evidence from China
Gongmeng Chen a, Michael Firth b,*, Daniel N. Gao a,c, Oliver M. Rui d
a Antai School of Management, Shanghai Jiaotong University, China
b School of Accounting and Finance, The Hong Kong Polytechnic University, Kowloon, Hong Kong, China
c Jinhe Centre for Economic Research, Xi’an Jiaotong University, China
d Chinese University of Hong Kong, Hong Kong, China
留學生畢業dissertationReceived 26 February 2005; received in revised form 7 September 2005; accepted 8 September 2005
Available online 2 November 2005
Abstract
Our study examines whether ownership structure and boardroom characteristics have an effect oncorporate financial fraud in China. The data come from the enforcement actions of the Chinese Securities
Regulatory Commission (CSRC). The results from univariate analyses, where we compare fraud and nofraudfirms, show that ownership and board characteristics are important in explaining fraud. However,using a bivariate probit model with partial observability we demonstrate that boardroom characteristics areimportant, while the type of owner is less relevant. In particular, the proportion of outside directors, thenumber of board meetings, and the tenure of the chairman are associated with the incidence of fraud. Ourfindings have implications for the design of appropriate corporate governance systems for listed firms.Moreover, our results provide information that can inform policy debates within the CSRC.D 2005 Elsevier B.V. All rights reserved.
JEL classification: G34
Keywords: Ownership; Corporate governance; Fraud; China’s enforcement actions
1. Introduction
China began a process of economic restructuring in the late 1970s and these reforms continueto this day. Principal aims of the reforms include the modernization of industry, stimulation of
0929-1199/$ - see front matter D 2005 Elsevier B.V. All rights reserved.
doi:10.1016/j.jcorpfin.2005.09.002
* Corresponding author. Tel.: +852 2766 7062; fax: +852 2330 9845.
E-mail address: [email protected] (M. Firth).
Journal of Corporate Finance 12 (2006) 424– 448
www.elsevier.com/locate/jcorpfin2. China’s economic restructuring, regulatory reforms, and prior research
2.1. Economic reforms
China’s enterprise reforms have been far-reaching. From a centrally planned economy wheremanagers of SOEs followed orders from government ministries, the reforms have devolved
powers to the restructured enterprises and given managers a lot of discretion over funding,products, pricing, and labor practices. Managers are increasingly being appointed on merit rather
than political patronage and personal connections.The enterprise reforms involve carving out the operational units of the SOEs4 and
reorganizing them as limited liability companies with share capital and with profit makingobjectives. Many of these companies have subsequently listed on the stock market and raised#p#分頁標題#e#
capital by IPOs. A major characteristic of China’s enterprise reforms is the state’s retention of acontrolling stake in listed firms.5 This stake is held directly by central government and its
associated ministries (including state asset management bureaus), and by city, regional, and localgovernment. On average, about 30% of the shares are owned by the state (central government),
its ministries, and local and regional government. Another 30% of the shares are owned by legalentities and most of these entities are ultimately owned by the state. One type of legal entity is anSOE. An SOE typically floats off part of its activities into a listed firm but it retains a majority orcontrolling stake in it. The listed entity is often the profitable operations of the SOE. Legalentities are required to maximize the return on their investments. The shares held by the state andlegal entities are not tradable on the two stock exchanges.6 The state and legal entityshareholders are typically blockholders and the largest blockholder often controls the firm asthey have substantially larger investment stakes than the second largest blockholder (there might
not even be a second blockholder) (Xu, 2004). On average, about 40% of a listed firm’s shares isowned by private individuals and private institutions, and these shares (called A-shares) areactively traded on the exchanges.7 About 10% of listed firms have also issued shares toforeigners (called B-, H-, and N-shares). All the shares, tradable and non-tradable, rank paripassuin terms of dividends and voting. In China, managerial and director stockholdings are verysmall and executive stock option schemes are rare during the period we investigate. For thisreason we do not examine executive stock ownership in our analysis of corporate financial fraud.The designation of shares into state, legal entity, and individual is enshrined in China’scompany law. Note that legal entities are ultimately owned by the state. However, legal entities(such as SOEs) have somewhat different objectives than state stockholders. Legal entities are
usually charged with making profits, whereas for state stockholders profit may not be the sole
4 The SOE, itself, remains 100% owned by the central or regional government. The SOE has a number of social and
political objectives that go beyond the making of profits (Bai et al., 2000).
5 Bortolotti and Faccio (2004) show that many governments keep a controlling or dominant ownership stake inprivatized SOEs. Thus China is not the only country where dpartial privatizationsT occur. Bortolotti and Faccio also findthat high state ownership in privatized SOEs results in superior financial performance (measured by the market to bookratio). Gupta (2005) finds that partial privatizations in India have a positive impact on a firm’s sales, profits, and laborproductivity. These findings stand in contrast to the results from China’s privatizations (Chen et al., 1998, in press-a),where high state #p#分頁標題#e#留學生畢業dissertationownership was found to be detrimental to financial performance.
6 The Shanghai Securities Exchange (SHSE) opened in December 1990 and the Shenzhen Stock Exchange (SZSE)opened in July 1991.
7 Shares owned by individuals are very actively traded. The average holding period has been estimated to be as little as
2 months (Poon et al., 1998).
G. Chen et al. / Journal of Corporate Finance 12 (2006) 424–448 427

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