Board Structure and Intragroup Propping: Evidence from Family Business Groups in Hong Kong

• Author: Yan‐Leung Cheung,In‐Mu Haw,Wenming Wang,Weiqiang Tan
• Date: 01 September 2014
• DOI: http://doi.org/10.1111/fima.12034
• Published date: 01 September 2014

Board Structure and Intragroup

Propping: Evidence from Family

Business Groups in Hong Kong

Yan-Leung Cheung, In-Mu Haw, Weiqiang Tan,

and Wenming Wang∗

Using earnings announcement events made by group member firms in Hong Kong, this study

examines the governance role of boards of directors in curbing propping activities within family

business groups. We find that earnings released by group member firms affect the stock prices

of their nonannouncing group peers in a manner consistent with intragroup propping. More im-

portantly, this effect is less pronounced when the announcing firms have a larger board or a

board with a higher proportion of independent directors, but more pronounced when they have

an executive director from their controlling families acting as board chairperson. Furthermore,

the monitoring effect of boards of directors is strengthened for firms subject to new regula-

tions increasing board power. Our results suggest that board oversight can mitigate propping

activities.

Family business groups play an important role in many economies around the world, and

typically consist of a number of legally independent firms under the common control of the same

family (e.g., La Porta, Lopez-De-Silanes, and Shleifer, 1999; Claessens, Fan, and Lang, 2006).1

One justification for the prevalence of family business groups is that member firms’ resources

could be transferred by their controlling families to prop up their financially troubled group peers

(Friedman, Johnson, and Mitton, 2003; Bae, Cheon, and Kang, 2008; Riyanto and Toolsema,

2008). To the extent that propping transfers wealth from nonfamily minority shareholders in one

firm to benef it family ownership in another firm, propping generates an agency problem that

may be mitigated by stronger governance structures. We explore this issue in a sample of Hong

Kong family owned businesses.

Intragroup propping can be undertaken in both direct and indirect ways. On the one hand, the

controlling families may transfer funds directlythrough various forms of related par ty transactions

from the healthier member firms to the f inanciallydistressed ones (Cheung, Rau, and Stouraitis,

2006; Gopalan, Nanda, and Seru, 2007; Jian and Wong, 2010). Such outright expropriation of

firm resources by the controlling families directly impairs the interests of minority shareholders

of the healthier member firms. On the other hand, the controlling families can inject their share of

retained earnings (distributed as dividends) from the healthier member firms into other member

∗Yan-LeungCheung is the President and Chair Professor of Public Policyat the Hong Kong Institute of Education. In-Mu

Haw is a Professor of Accounting at the Neeley School of Business at Texas Christian University in Fort Worth, TX.

WeiqiangTan is an Assistant Professor of Finance at the Hong KongBaptist University, Hong Kong. WenmingWang is a

Research Assistant Professorof Accounting at the Hong Kong Baptist University, Hong Kong.

1Followingprior literature (e.g., Claessens, Djankov, and Lang, 2000; Claessens et al., 2002; Villalongaand Amit, 2010),

this study defines family as a group of people related by blood or marriage and focuses on total ultimate ownership held

by each family,but does not consider ownership held by individual family members separately.Accordingly, we measure

cash flow rights of the controlling family in individualmember f irms as the sum of direct and indirect ownership held by

all family members.

Financial Management •Fall 2014 •pages 569 - 601

570 Financial Management rFall 2014

firms in f inancial distress or with better investment opportunities (Gopalan, Nanda, and Seru,

2011). The interests of minority shareholders would be undermined if the (over) distribution of

retained earnings impaired the ability of the healthier member firms to pursue value-increasing

investment opportunities. Therefore, the controlling families’ intragroup propping may benefit

the aggregate value of their business groups as a whole or their own welfare at the expense of the

minority shareholders of member firms from which resources have been siphoned off. Following

Bae, Cheon, and Kang (2008), we measure intragroup propping potential based on the stock price

reactions of nonannouncing member firms to earnings announcements of member f irms within

family business groups. Good news regarding earnings released by member firms indicates a

potential increase in the resources available for intragroup propping, while bad news regarding

earnings may signal fewer resources available to share, or even the need for reverse propping by

nonannouncing member firms. Thus, the market reactions of nonannouncing member f irms to

earnings announcements made by their group peers can be considered as the market’s ex ante

valuation of intragroup propping, and are expected to be positively associated with those of

announcing member firms to the extent of propping (Bae, Cheon, and Kang, 2008). In a narrow

sense, this captures “negative tunneling” activities.

This study utilizes earnings announcement events because they havesome advantages over other

propping-related events that lead to dramatic increases in firm value. Earnings announcements

are common to all public group member firms where detailed information on resource changes

is available; this providesus with suff icient sample observations to ensure the statistical power of

our tests. The observed intragroup propping effect manifested in earnings announcements could

also be easily generalized to other cases, since earnings announcements tend to render more

conservative tests on propping behavior than other sizable events (Bae, Cheon, and Kang, 2008).

The board of directors is introduced as the highest internal control mechanism responsible

for curbing agency conflicts between a firm’s insiders and outsiders (Fama and Jensen, 1983).

However, little is known about the role of boards of directors in mitigating the agency conflicts

underlying intragroup propping between controlling families and minority shareholders. This

study aims to fill this void. Given that the effectiveness of boards of directors is principally

determined by board structure, this study focuses on three fundamental characteristics of board

structure in group member firms: (i) board size, (ii) board independence, and (iii) board leadership

(whether board chairperson comes from the controlling family), and examines the role that these

board characteristics play in curbing intragroup propping activities.

A larger board could constrain the intragroup propping ability of controlling families because

a larger board is able to commit more time and effort to overseeing insiders and might be optimal

for firms with higher levels of private benefits to insiders (Monks and Minow, 1995; Raheja,

2005; Harris and Raviv, 2008). Thus, we hypothesize that stock prices of nonannouncing mem-

ber firms react less to earnings announcements made by their group peers with a larger board.

The introduction of independent directors would accentuate board effectiveness in disciplining

insiders, as independent directors contribute stronger independence and objectivity than their

inside counterparts due to human capital development and reputation concerns (e.g., Byrd and

Hickman, 1992; Gillette, Noe, and Rebello, 2003). A board with stronger independence would

work more effectively to discourage controlling families from undertaking intragroup propping.

Thus, we hypothesize that the stock prices of nonannouncing member firms react less to earn-

ings announcements made by member firms with a board composed of a higher proportion of

independent directors.

Among board members, the chairperson plays a more influential role than other directors

in corporate governance activities. Seizing the position of board chairperson helps controlling

families to enlarge their scope to undertake intragroup propping activities. We thus hypothesize

Cheung, et al. rBoard Structure and Intragroup Propping 571

that the stock price reactions of nonannouncing member firms are more pronounced to earnings

announcements made by member firms with a person related to their controlling families serving

as board chairperson.

Wetest our hypotheses based on a sample of member f irms of family business groups listed on

the Hong Kong Stock Exchange (HKSE) over the period 2002 to 2008. The Hong Kong market

provides an ideal research setting to address our research questions, for the following reasons.

First, family business groups dominate the Hong Kong economyand many of them control two or

more member firms publicly traded on the HKSE. Ownership and control structures are publicly

disclosed in annual reports, which enable researchers to identify listed group member firms and

their group membership. Second, controlling families in Hong Kong are actively involved in

making strategic and resource allocation decisions among member firms under Chinese Guanxi

culture, which is characterized by a personal networking system (Carney, 2008). The active

involvement by controlling families in management makes their member firms vulnerable to

propping behavior.Third, corporate governance substantially affects firm’svalue creation in Hong

Kong (Cheung et al., 2011). Corporate governance practices in Hong Kong have been influenced

by the Anglo-American paradigm due to Hong Kong’s history as a former British colony; these

practices place special emphasis on boards of directors in protecting outside investors (Allen,

2000; Cheung, Rau, and Stouraitis, 2006).

Weconstruct our sample of family business groups through manual collection of ownership data

as of the end of fiscal year 2005 from annual reports for all public fir ms listed on HKSE. A single-

country study could be more advantageous than cross-country analyses in studying the intragroup

propping phenomenon. Firms in the same country face the same legal institutions, corporate

control market, accounting standards, tax codes, and other country-level factors, which are likely

to affect the propensity of controlling families to undertake intragroup propping activities. Thus,

a within-country sample highlights the effect of firm-level variation in corporate governance

arrangements, while holding all country-level latent factors constant for all sample firms.2

Our empirical analyses reveal that the stock price reactions of nonannouncing member firms

are positively associated with those of their announcing group peers around the latter’s earnings

announcements, suggesting the existence of intragroup propping; this result is consistent with

Bae, Cheon, and Kang (2008). More importantly, the positive association between the market

reactions of nonannouncing and announcing member firms is less pronounced to earnings an-

nouncements made by member firms that have a larger board and a board with a higher proportion

of independent directors. This suggests that boards with larger size and stronger independence in

member firms work more effectively to deter controlling families from undertaking intragroup

propping activities.

Our findings are consistent with the theoretical proposition that boards with larger size and

stronger independence are demanded by firms with higher level of private benefits to insid-

ers (Raheja, 2005; Harris and Raviv, 2008). In contrast, the positive association between the

market reactions of nonannouncing and announcing member firms is more pronounced to earn-

ings announcements made by member firms with board chairperson coming from their con-

trolling families, suggesting that securing the power of the board chairperson facilitates intra-

group propping activities undertaken by controlling families. Overall, our results suggest that

2In addition, single-country analysis can avoid the endogeneity problems between corporate governance mechanisms

adopted by firms and regulatory institutions. Prior literature shows that the underlying system of corporate laws and

regulations, to a great extent, determines firm choices of corporate governance mechanisms within a given country

(La Porta et al., 1998, 2000; Denis and McConnell, 2003). It would be difficult for a cross-country analysis to clearly

disentangle the effect of firm-level corporate governance choices from that of country-level regulatory institutions.