Parasites and Paragons: Ownership Reform and Concentrated Interest among Minority Shareholders

• Author: Jing Shi,Nan Jia,Yongxiang Wang,Changyun Wang
• Date: 01 January 2020
• Published date: 01 January 2020
• DOI: http://doi.org/10.1111/joms.12537

© 2019 Society for the Advancement of Management Studies and John Wiley & Sons, Ltd.

Parasites and Paragons: Ownership Reform and

Concentrated Interest among Minority Shareholders

Nan Jiaa, Jing Shib,c, Changyun Wangd and

Yongxiang Wanga

aUniversity of Southern California; bShandong University of Finance and Economics; cMacquarie

University; dRenmin University of China

ABSTRACT Do investors with concentrated shareholding infringe on the value of more-

fragmented shareholders (‘parasites’) or facilitate the growth of fir m value for all shareholders

(‘paragons’)? In a major ownership reform of Chinese listed firms, we obtain evidence which

suggests that larger minority shareholders undertook certain actions both for a rent-seeking

purpose – that these actions allowed them to reap private benefits at the expense of smaller

minority shareholders, and for a value-creating purpose – to potentially increase firm value after

the reform. It is plausible that both drivers co-existed, but they generated different implications

of wealth redistribution. When institutional constraints on rent-seeking were ineffective, higher

concentration of minority shares decreased the immediate gains captured by the small investors

who held minority shares at the time of the refor m, but increased the future value of the fir m to

be divided among for all investors, large and small, who held firm shares after the reform.

Keywords: China, concentrated interests, corporate governance, minority shareholders,

rent-seeking

INTRODUCTION

The shareholder heterogeneity in terms of ownership size has generated much tension in

corporate governance. On the one hand, a large body of literature on emerging market

firms cautions against the expropriation by controlling shareholders at the expense of

minority shareholders. For example, tunnelling (also known as the principal-principal

conflict) occurs when controlling shareholders infringe on the interest of minority share-

holders by exploiting the gap between control rights and cash-flow rights (i.e., residual

rights) (e.g., Johnson et al., 2000; La Porta et al., 1999). On the other hand, in broader

Journal of Man agement Studi es 57:1 January 2020

doi:10. 1111/j om s.1 253 7

Address for reprints: Nan Jia, Marshall School of Business, University of Southern California, HOH 518,

710 Exposition Blvd, Los Angeles, CA, 90089 (nan.jia@marshall.usc.edu).

130 N. Jia et al.

© 2019 Society for the Advancement of Management Studies and John Wiley & Sons, Ltd.

contexts that also include developed markets, researchers argue that the more frag-

mented the shareholders are, the lower the incentives they have to become fully informed

for the purpose of making the best decisions for the firm, so holders of more concen-

trated shares are more likely to become the guardians of fir m value (e.g., Larcker et al.,

2015). For example, blockholders often actively monitor management whereas smaller

shareholders freeride on the efforts of the former (Daily et al., 2003; Dalton et al., 2003;

David et al., 1998). Researchers commonly call this tension between concentrated and

fragmented shareholders the ‘paragons or parasites’ dilemma (e.g., Khanna and Yafeh,

2007). Indeed, the ‘tug of war’ between these shareholders can become nuanced and

complex, in that both can take actions to create a larger ‘pie’ (firm value) while compet-

ing to capture a bigger share of the ‘pie’ for themselves (Jia et al., 2018).

Exploiting the opportunities to observe the division of value among different types of

shareholders, above and beyond changes of the overall firm value, will enable research-

ers to more deeply examine this tension. In this paper, we take advantage of the empir-

ical opportunity of directly observing the outcomes of negotiation (which are publicly

disclosed) between different types of shareholders that occurred in a major reform of all

publicly listed firms in China (which is called the ownership-split reform). Reform poli-

cies stipulated that shareholders who held different types of shares in each fir m – i.e., the

controlling shareholders who held ‘non-tradable shares’ and minority shareholders who

held ‘tradable shares’ – negotiate with each other over the compensation to be paid by

the former to each share held by the latter (i.e., a uniform rate of compensation for each

share held by minority shareholders) such that minority shareholders would collectively

approve a significant change to the firm’s equity contract. This change aimed to elimi-

nate ‘non-tradable shares’ and allow them to trade on the secondary market, which was

desired by controlling shareholders and also believed to improve firm value. The nego-

tiated compensation thus represented a transfer of wealth from controlling shareholders

to minority shareholders.

Our research is motivated by noting a puzzling outcome. According to the collective

action theory (Olson, 1971), the presence of more concentrated ownership of tradable

shares should enable minority shareholders to more effectively negotiate with controlling

shareholders, because larger minority shareholders are thought to have stronger incen-

tives to produce the common good that benefits all minority shareholders despite freerid-

ing by others. In our research context, it means that larger minority shareholders should

have stronger incentives to exert effort to negotiate for a higher rate compensation given

to each minority share. Therefore, greater concentration of shareholding among mi-

nority shareholders should lead to a higher compensation rate. However, contrary to this

expectation, we found the opposite phenomenon had occurred: that higher concentra-

tion of minority shareholdings was associated with lower rates of compensation.

We first examine an explanation based on rent-seeking by larger minority sharehold-

ers. Numerous anecdotes including media reports stakeholder outcry during the reform

(e.g., Huang, 2006a, 2006b; Li et al., 2006; Sun, 2006, among many other reports) indi-

cated that in some firms, the minority shareholders that held more shares sought to strike

private ‘backdoor’ deals with controlling shareholders, in which the former agreed to ap-

prove lower rates of compensation in exchange for secret side payments from controlling

shareholders. They took advantage of the rules that each minority share had one vote,

Parasites and Paragons 131

© 2019 Society for the Advancement of Management Studies and John Wiley & Sons, Ltd.

and collective approval of a compensation plan was determined by the votes of two-

thirds of the minority shares whose holders attended the meeting, so those with more

minority shareholding wielded greater influence over the voting outcome. In this way,

larger minority shareholders illegally ‘hijacked’ minority shareholders’ collective bar-

gaining with controlling shareholders, at the expense of smaller minority shareholders.

We examine the theoretical possibility that concentrated shareholding create opportuni-

ties for larger minority shareholders to engage in rent-seeking at the expense of smaller

minority shareholders. Based on this theory, we are able to explain a negative relation-

ship between minority shareholding concentration in a firm and the rate of compensa-

tion agreed upon by the firm’s minority shareholders. The rent-seeking explanation is

not only consistent with the view of concentrated interest as ‘parasites’, but suggests a

new channel that does not have to rely on the traditional channel in tunnelling which is

the gap between control rights and cash flow rights. Instead, collective bargaining will fail

if those with more power are able to sidestep the official bargaining channels.

We then examine an alternative explanation which is broadly consistent with the view

of larger shareholders as ‘paragons’. The motivation of this reform was that allowing

controlling shareholders’ shares to trade on the secondary market would increase their

incentives to improve firm value. An assumption that larger minority shareholders are

more interested in firm value in the longer term whereas smaller minority shareholders

are more interested in obtaining immediate compensation will lead to the conclusion that

the holders with more concentrated minority shares would be willing to accept a lower

rate of compensation to facilitate the completion of the reform. This explanation ap-

pears to be consistent with the difference-in-differences estimation which compares firm

value three years before and after the reform and demonstrates that higher concentration

of minority shares at the time of the reform increases post-reform firm valuation.

Therefore, large minority shareholders can be both ‘paragons’ and ‘parasites’ in our

context and it is not a self-contradictory conclusion. They may have allowed lower com-

pensation to be paid to each minority share partly because they reaped private benefits

from backdoor deals during the reform and partly because they expected to benefit more

from improved firm value after the reform – and thus were more willing to give up

some compensation to achieve this goal. The combined benefits may have shaped their

behaviour in the negotiation. However, these drivers produce different implications for

the redistribution of wealth – or the question of which minority shareholders paid more

costs as opposed to capturing more the benefit of the reform.

Our subsequent analysis of moderating conditions aims to shed some light on this

question. These moderating conditions include the presence of foreign investors in the

firm, the firm’s location in cities with stronger legal protection, and higher-quality in-

ternal governance, all of which we argue constrain backdoor deals at the time of the

reform. We find that facing weaker constraints on backdoor deals, higher concentration

of minority shares reduces the negotiated compensation to an even greater extent, which

further supports the rent-seeking view. In such firms – i.e., those that both have more

concentrated minority shareholding and face weaker constraints of backdoor deals, each

minority share receives the lowest amount of wealth transfer (compensation) during the

reform than in other firms. However, we also find the post-reform valuation of these

firms turns out to be the highest, which suggests that all post-reform shareholders of