Estimating the Extent of Propping in China and How It Is Affected by the Controlling Shareholder's Capture of Directors and Executives

Abstract

Research on the phenomenon of propping up a firm’s earnings or liquidity by its controlling shareholders through related-party transactions (RPTs) has suffered from arbitrary and unsettled measures of the ‘propping’ variable and a lack of theoretically underpinning. This study’s first objective is to develop a new measure of propping based on an estimation of the proportion of propping embodied in total related-party transactions. By invoking Jensen and Ruback’s (1983) theory of ‘market for ownership control’, the propping component is estimated from prevailing conditions that can trigger a market for ownership control of a firm or shield its controlling shareholders from this market. Using this theory-based estimate of the extent of propping by a firm, the second objective of this study is to investigate the extent to which controlling shareholders are able to capture directors and top executives in order for the firm’s board governance to facilitate the carrying out of propping transactions. Models are developed and empirically tested in the context of listed companies and securities regulations in China. Using the CSMAR database for the year 201'8 all companies with complete data on the Shanghai and Shenzhen Stock Exchanges are sampled. Results reveal that the key factors deemed to create a market for ownership control – namely, lower State (and State legal person) ownership, greater risk of penalty by the securities regulator and a weaker cushion of non-tradeable shares – are significant conditions affecting total RPTs. The regression coefficients of these factors provide the estimate of the propping component in total RPTs. Over the whole sample propping is found to be approximately 1.5% of total RPTs. This propping measure is then modelled as the dependent variable, and regressed against governance factors that are proxies for the extent of ‘capture’ by controlling State shareholders of directors, supervisors and top executives. The results reveal that the extent of propping is significantly positively affected by the extent of directors’ shareholdings in the firm and the top 3 executives’ emoluments. This paper establishes a new measurement approach that can be adopted in future studies on the phenomenon of propping. It also has practical implications for minority shareholders and prospective investors in terms of developing a firm-level ‘propping’ index and providing a better understanding of how controlling shareholders can ‘capture’ directors and executives to facilitate propping transactions.

Keywords: Related-party transactions, propping, controlling shareholders, non-tradable shares, governance, capture, directors and executives, China

JEL Classification: M40