Corporate Governance, Political Connections, and Intra‐Industry Effects: Evidence from Corporate Scandals in China

• Author: Xin Yu,Ying Zheng,Peng Zhang
• DOI: http://doi.org/10.1111/fima.12064
• Published date: 01 March 2015
• Date: 01 March 2015

Corporate Governance, Political

Connections, and Intra-Industry Effects:

Evidence from Corporate Scandals

in China

Xin Yu, Peng Zhang, and Ying Zheng∗

This paper investigates intra-industryspillover effects of corporate scandals in China. Wedemon-

strate how a contagion effect spreads to peer firms depending upon the quality of corporate

governance and their political connections. Good corporate governance in peer firms reduces

the contagion effect of scandals. External governance has a stronger influence on reducing the

contagion effect of both financial and non-financial scandals, while ownership concentration and

the quality of auditors play a more pronouncedrole in mitigating the contagion effect of financial

scandals. State ownership helps to mitigate the negative influence of non-financial scandals in

individual-owned firms, but not in state-owned enterprises.

Public attention to corporate scandals has increased in the wake of financial malfeasance,

such as that practiced at Enron and WorldCom, given the concern for the serious economic

consequences that they cause.1For example, corporate scandals could spoil firms’ reputations

(Karpoff and Lott, 1993), impair firm value (Nourayi, 1994), disrupt regular operations and

produce changes in key personnel (Agrawal and Chadha, 2005; Chen et al., 2005), or even

threaten the survival of related firms. These studies indicate that scandals present a high risk

to firms, investors, and the market. However, few academic studies explore the externalities

generated by corporate scandals using a large sample.2This paper attempts to fill that gap by

investigating the variation in the contagion effect of corporate scandals on peer firms.

Prior research documents the information transfer effect associated with corporate events,

such as bankruptcy (Lang and Stulz, 1992), management buyouts (Slovin, Sushka, and Bendeck,

The authors would like to thank Raghu Rau (Editor), an anonymous referee, Siu Kai Choy, Zhaoyang Gu, Oliver Z.

Li, Bin Ke, Donghui Wu, conference participants at the Chinese Accounting Professors’ Association of North America

(CAPANA)Annual Conference 2010, and seminar participants in the Business School, Sun Yat-senUniversity. Yu gratefully

acknowledges financial support from the National Natural Science Foundation of China (Grant No. 71272101)and the

New Staff ResearchStart-Up Fund of the Faculty of Business, Economics, and Law, The University of Queensland. Zheng

gratefullyacknowledges financial support from the National Natural Science Foundationof China (Grant No. 71002059),

from the National Science Foundationof China (Grant No. 71332004), and from the Fundamental Research Funds for

the Central Universities (GrantNo. 1209130). All errors remain our own.

∗Xin Yuis a Senior Lecturer of Accounting in the Business School at the University of Queensland in Brisbane, Australia.

PengZhang is the Head of the International Business Development Department at the China Financial Futures Exchange

in Shanghai, PRC. Ying Zheng is an Assistant Professor of Accounting in the Business School at Sun Yat-sen University

in Guangzhou, PRC.

1In this paper, corporate fraudand scandal are used interchangeably.

2An exception is Gande and Lewis (2009) who finds negative stock price reactions to both lawsuits against firms and

peer firms using a large sample of shareholder initiated class action lawsuits. The negative market reaction to peer firms

is significantly related to the possibility of being sued.

Financial Management •Spring 2015 •pages 49 - 80

50 Financial Management rSpring 2015

1991), takeover and restructuring activities (Mitchell and Mulherin, 1996), earnings releases

(Foster,1981), equity offerings (Szewczyk, 1992), dividend announcements (Firth, 1996), capital

investment announcements (Chen, Ho, and Shih, 2007), and accounting restatements (Gleason,

Jenkins, and Johnson, 2008). Building on the information transfer literature, we suggest that

corporate scandals discovered at one firm may cause investors to reevaluate their position with

respect to the increased uncertainty associated with future performance in other fir ms within the

same industry. In this paper, we focus on two important factors: 1) corporate governance and 2)

political connections. As noted in the literature, corporate fraud is associated with weak corporate

governance (Beasley, 1996; Dechow, Sloan, and Sweeney, 1996; Alexander and Cohen, 1999;

Agrawal and Chadha, 2005; Farber, 2005; Chen et al., 2006). It is plausible that the disclosure

of corporate scandals reveals a failure of corporate governance causing investors to reassess the

likelihood of corporate fraud occurrences in peer fir ms. In addition, a growingbody of empirical

evidence suggests that political connections are a source of value for firms. Political connections

benefit fir ms byproviding business opportunities, preferential access to f inancing, lowertax rates,

preferential access to government funding, and bailout possibilities (Fisman, 2001; Faccio,2006;

Claessens, Feijen, and Laeven, 2008; Ferguson and Voth, 2008;Goldman, Rocholl, and So, 2009,

2013; Wu et al., 2012). The disclosure of corporate scandals raises concerns regarding the value

of these political connections. Political favors to firms with political connections may reduce the

likelihood of being investigated when competitors are involved in scandals. However, political

connections may be less useful in these circumstances as politicians are likely to withdraw their

support when scandals occur to avoidany blame for investor losses (Wattsand Zimmerman, 1986).

Thus, it is also plausible that investors will reassess the value of a firm’s political connections

when its competitors are involved in scandals.

Based on a sample of 412 corporate scandals in China, we find that announcements of corpo-

rate scandals result in a decline in the stock prices of peer firms, suggesting a contagion effect.

Furthermore, consistent with our hypothesis, we determine that good corporate governance alle-

viates spillovers of bad news from corporate scandals experienced by competitors. We measure

corporate governance from both external and internal perspectives. We evaluate external cor-

porate governance using regional legal protection and local economic development indicators.

Our empirical findings demonstrate that the contagion effect is more pronounced when both

peer firms and scandal f irms are located in regions with weaker investor protection and in less

developed economies, suggesting that the institutional environment is an effective external gov-

ernance mechanism in China. We examine internal corporate governance along two dimensions:

1) ownership structure and 2) audit quality. We find that peer firms with a higher percentage of

outside, noncontrolling blockholdings are less susceptible to the contagion effect of corporate

scandal announcements, suggesting that outside, noncontrolling blockholders effectivelymonitor

the controlling (ultimate) shareholder. We also confirm that the appointment of Top 10 auditors

(based on the total assets of customers audited in China’s stock market) in peer firms is associated

with a smaller contagion effect, suggesting that audit quality plays an important role in reducing

information asymmetries in China (Gul, Kim, and Qiu, 2010).

Then, we examine the impact of political connections on the degree of contagion among peer

firms. We measure corporate political connections with respect to both ownership types and top

managers’ personal networks. The empirical results indicate that when scandal firms are not

state-owned, while peer firms are state-owned, the contagion effect is the weakest suggesting

that political favors to state-owned enterprises (SOEs) help to mitigate the negative influence of

scandals in non-SOE competitors. However, when scandal firms are SOEs, peer firms suffer a

greater negative influence, irrespective of whether they are SOEs or non-SOEs, suggesting that

political favors become irrelevant in influencing the contagion effect when scandal firms are

Yu, Zhang, & Zheng rCorporate Governance, Political Connections, and Intra-Industry Effects 51

SOEs. When measuring political connections with top managers’ personal networks, we find

that peer firms suffer greater negative effects when both the scandal firm and the peer fir ms

have politicallyconnected Chairman or chief executive officers (CEOs), suggesting that investors

believe political connections become less useful in this circumstance as politicians are likely to

withdraw their support discounting the value of peer firms with political connections.

Wefurther separate cor porate scandals into financial and non-financial categories to determine

whether these two types of scandals are monitored bydifferent corporate governance mechanisms

and whether outside investors are sensitive to these differences when evaluating peer firms in

China. Our empirical results indicate that external governance mechanisms are significant in

reducing the spillover effect of both financial and non-financial fraud announcements on peer

firms. In contrast, corporate governance, when measured as outside blockholdings and auditor

quality, playsa signif icant role in reducing the contagion effect of financial scandals, but not that

of non-financial scandals. Political connections play significant roles in influencing the contagion

effect of scandals, but they only do so in the non-financial fraud group, not in the financial fraud

group.

Selecting China as the area of study is appropriate for several reasons. First, China is a country

where firms have both concentrated ownership and significant state ownership, providing us

the opportunity to examine how political connections affect the spillover effect of corporate

scandals. In addition, legal enforcement in China is weak. Firms tend to resort to illegal measures

in operations, precipitating scandals not only in financial reporting but also in other activities.

Thus, we can investigate a wide range of corporate scandals in forms other than financial

reporting. Moreover, the level of local economic development and institutional environments

vary dramatically across regions in China (Wang, Wong, and Xia, 2008; Cheung, Rau, and

Stouraitis, 2010; Chen et al., 2013; Fan, Gillan, and Yu, 2013) providing uswith an oppor tunity to

examine how differences in external governance affect firm value. Finally, Chinese stock markets

have serious asymmetric information problems (Morck, Yeung, and Yu, 2000), such as a lack

of regulations and legal enforcement, insufficiently knowledgeable managers, and the deliberate

withholding of information. The presence of asymmetric information is likely to result in a

contagion effect as outside investors rely on information about a single firm as an indirect signal

of the valuation of other firms, especially firms in the same industr y.

Our study contributes to the literature in the following ways. First, we provide new evidence

concerning the externalities of corporate scandals by demonstrating that scandals are not neces-

sarily idiosyncratic and can convey common information on an industry’s corporate governance.

In addition, we investigatethe contagion effect at the f irm level, whilemost prior studies examine

contagion or competition effects at the industry level. Moreover, our study is related to research

investigating stock price synchronicity in China and other emerging markets. Morck et al. (2000)

for example, find that high synchronicity is correlated with weak protection for investor prop-

erty rights, while Gul et al. (2010) demonstrate that firm-level investor protection is inversely

associated with synchronicity. In addition to investor property rights protection, Jin and Myers

(2006) note that in a country with a weaker institutional environment, a negative shock from one

firm could more easily spill over to other firms and translate into increased industry and market

risk. Our paper extends and complements these studies by providing a channel to explain the

association between weak investorprotection and stock price synchronicity: the contagion effect

of corporate scandals.

The remainder of the paper is organized as follows. Section I introduces the background for

this study. Section II develops testable implications concerning the information spillover effects

of corporate scandals. Section III presents the research design, while Section IV describes the

sample selection procedures and provides descriptive information concerning the scandal events.