Economic Management Journal August 2015, Volume 4, Issue 3, PP.47-51
Analysis and Countermeasures on Equity Concentration Kun Deng International Marketing Departement II, Zhongyuan Engineering Corp., Beijing, 100191, China Email: k.d.123@126.com
Abstract This paper starts from the concept and distribution of Tunneling. The main reason of Tunneling is the concentration of Equity and the incompletion of legal protection for small and medium-sized investors. Tunneling not only infringes small and medium-sized shareholders’ interest, but also violates company’s benefit, and further damages the interest of creditors. Tunneling proceeds in variety of ways, one of them is Related Party Transaction, which severely erodes company’s benefit. The suggested countermeasure for Tunneling is adjusting the property structure, completing the legislation and improving the independent director system. Keywords: Tunneling Effect; Tunneling; Related Party Transaction
1 INTRODUCTION In corporate governance structure, ownership concentration can improve the efficiency of management regulation to some extent, however, what shouldn’t be ignored is that equity concentration also leads to big shareholders encroaching on minority shareholders’ interest and company’s benefit, which is called Tunneling. Tunneling will reduce the value of the company. This article starts from the concept of tunneling, and discusses the mechanism of tunneling and the corresponding harm, and then gives some management advice.
2 THE CONCEPT OF TUNNELING Tunneling has different meanings in different fields, as far as corporate governance is concerned, the concept of Tunneling can be traced back to 2000, in a paper titled Tunneling, written by Johnson，La Porta，Lopez-de-Silanes and Shleifer. Johnson argues that once the company’s equity is concentrated, tunneling will appear. Johnson etc. defined tunneling as minority shareholders transfer the underlying company’s funds to the controlling shareholders through repurchasing stock, transferring asset, transferring price, inside trading and many other ways based on the Pyramid shareholding structure. As a result, the underlying company small shareholders’ interests are violated. Tunneling involves two types of behaviors: the first, operational tunneling, which mainly refers to the controlling shareholder lifting the executive compensation and other forms of self-transaction by means of theft and fraud, nonmarket asset sales, related loans. The second, financial tunneling, which means controlling shareholders jeopardizing the interests of minority shareholders and eventually benefiting the controlling shareholders through dilution, buying out minority shareholders, insider trading, periodic acquisition or other financial transactions. Therefore, operational tunneling is accompanied with direct company’s resources delivery; while financial tunneling happens with unfairly transferring the company’s earnings. Tunneling exists all around the world. The company’s equity is more likely to be concentrated in East Asian countries due to nepotism phenomenon. People related with controlling shareholders were appointed to the company executives, which covers more than 60% companies in East Asia countries. The consequence is that the company’s ownership structure is very single, based on pyramid shareholding structure and the characteristics of the cross shareholding enterprises, the controlling shareholders are much easier to achieve full control of corporate resources and even enterprise group. Under this kind of ownership structure, it’s difficult to separate the ownership and - 47 www.emj-journal.org
controlling of the company, which also suggested that there is great incentive for the controlling shareholders, that is to say, the controlling shareholders have natural opportunities to violate the interests of small shareholders (Claessens et al, 2000). In Western European countries, in addition to the British and Irish companies, equity concentration exists widely, and the phenomena of benefit expropriation are not less serious than East Asian companies (Faccio, Lang, 2002).In countries such as Germany and Japan, the listed companies also have conflicts of interest between large shareholders and small shareholders (Rajan, 1992; Frank, Mayer, 1994).
3 THE GENERATING MECHANISM OF TUNNELING Whether tunneling will be generated depends on the degree of equity concentration and the protection from the law. Equity concentration will lead to a few major shareholders controlling the enterprise. Considering their own interest, big shareholders often take up or transfer the assets and profits of the company through their controlling rights. Studies have shown that the most enterprises in less developed countries or regions, including some large enterprises didn’t adopt dispersed ownership, because the shareholders of the enterprises, especially of big enterprises in these countries mainly are government agencies, or some big families. The enterprises adopting dispersed ownership are mainly in some British and American countries. Related laws in these countries is more mature, and providing more protection for investors (LLS, 1999). Shleifer and Vishny’s study (1997) found that when large shareholders’ controlling of the company exceeds a critical point, it can completely control the enterprise, at mean time obtain the private benefits from controlling that small shareholders can’t get. Many studies about controlling rights of enterprises postulate that there is a particular holding threshold value, and take it as standard to determine the attributes and the type of the enterprises. If the shareholders’ equity ratio exceeds the threshold, then the big shareholders are the controlling shareholders. According to voting probability and certain assumptions, Cubbin and Leech (1983) deduced the formula of effective control: P*=Zα[πH/(1+πZα2)]1/2 . Among them, P*means controlling threshold value, Zα means z value when P(z≤Z)=α is in accordance with normal distribution, α means the probability that large shareholders winning the right to vote in the shareholders general meeting, π means the probability of other shareholders vote in addition to the first big shareholder, H means Hofi Del coefficient for shareholding concentration. Friedman etc. argues that through pyramid shareholding structure, cross-shareholdings and issuing multiple equity shares, big shareholders can obtain greater actual control than their corresponding nominally control, which is more likely to induce various predatory behaviors. In the countries where law system is relatively complete, tunneling phenomena are less serious, the reason is that the degree of legal protection for investors has a negative relationship with equity concentration. The more protection in law for small and medium investors, the more can efficiently restrain on large shareholders encroaching on the interests of medium and small shareholders. On the other hand, in the countries or regions where investment protection is not perfect, tunneling behaviors are more rampant as a result of equity concentration. At the same time, tunneling also need to comply with relevant laws to avoid the legal regulation, so tunneling decision are often made by controlling management or the controlling shareholders of the company, because they have the right to arrange and implement general corporate decision making, we can find this kind of phenomena in many countries around the world. There is big difference between controlling shareholders, the ultimate controllers maybe government, big families, public companies and institutions, etc. Holding group in transition economies can more easily sell or transfer the product or the assets of the company at below-market price, because the countries adopting continental law system provide less protection for small-medium investors and creditors than those who adopts the US and the UK practice law (La Porta,1998; Coffee,1999). Tunneling behaviors are also very common in the developed economies in Europe. The reason is that mandatory bid rules made by European Union aiming at protecting the interests of small shareholders are evaded or exempted by regulators, which thus leads to tunneling behaviors prevailing (Kirchmaier, Grant, 2005).
4 THE DAMAGE OF TUNNELING Tunneling reflects the conflict between large shareholders and small shareholders, it violates the interest of small - 48 www.emj-journal.org
shareholders and affects the capital market’s normal operation. Johnson etc. (2000) found that the effectiveness of protection for company investors is more able to explain exchange rate depreciation and plunging stock-markets phenomenon in the Southeast Asian financial crisis from 1997 to 1998 than the general macroeconomic impact factors. Morck and Yeung etc. (2000) did research on the association of stock market price information and national economic development, and found that the controlling shareholders tunneling behaviors reduced the allocation efficiency of capital market, as well as the transparency of the whole economy. Tunneling also distorted the accounting earning data, and made it difficult for outside investors to evaluate enterprise financial situation correctly. Betrand etc. (2000) studied Indian firms and found that it’s common that the ultimate controller of pyramid pattern equity structure excavates the underlying company through tunneling effect. Therefore, India’s national economy was damaged seriously. Atansasov etc. (2006) researched on Bulgarian companies and came to the conclusion that small and medium-sized shareholders cannot effectively exercise the right of pre-emption, while controlling shareholders can implement low price issuing by themselves. After diluting the rights and interest of small shareholders, the controlling shareholders implemented market price manipulation, which leads to 70% of listed company delisted. Tunneling also manifests as related party transactions. La Porta etc. (2003) found that one of the reasons for poor management and even the collapse of the banks of Mexico is associated with lenders excavating banks. Cheung etc. (2005) studied Chinese listed companies and state-owned holding companies and found that related party transaction between shareholders eroding away 34% of the turnover. Charumilind etc. (2006) researched Thailand banks before financial crisis and found that the companies associated with government officials or bank executives got lots of convenience in access to bank loans, and more favorable long-term loans. The bad loans from the related party transactions speeded up the Thailand banks collapse in the subsequent financial crisis.
5 GOVERNANCE FOR TUNNELING Since Tunneling comes from equity concentration, we suggest that the governance for tunneling might be executed from the following aspects. Firstly, the structure of property rights should be adjusted and the investors should be diversified. Ownership structure is the foundation in corporation governance, which plays a critical role for components of corporate governance in actual operation. On one hand, equity dispersed overly will lead to no incentive to supervise management, on the other hand ownership concentration is likely to induce big shareholders or insiders eroding medium-small-sized shareholders. Therefore, how to get optimal equity allocation is a problem to be worthy researched. When equity concentration appears, company property right structure need to be adjusted as to protect the interests of minority shareholders. Decreasing big shareholders’ stake also can improve the company’s equity structure, and harmonize all kinds of equity ownership. Mutual checks and balances between various levels in corporate governance structure should be guaranteed, as well as decision-making and management, constraint mechanism existence and normal operation at the same time, which can actually protect the interests of small and medium shareholders. Secondly, the legislation should be completed and the protection for small and medium-sized investors should be strengthened. As far as China is concerned, regarding the actual situation in our country, implementing and strengthening the function of the board of directors and board of supervisors can protect the small shareholders in a certain extent. According to Company Law of the People’s Republic of China, corporate governance structure is defined as including general meeting of shareholders, board of directors, board of supervisors and managers, among them, the board of supervisors is responsible for the company’s internal supervision function. Supervision and inspection of the board of supervisors should be strengthened to protect the interests of small shareholders and the company’s benefit. Supervision and constraint mechanism should be perfected and the insiders seizing the interests of externals should be reduced to protect the rights and interests of all kinds of shareholders. In practice level, board of supervisors should be elected according to Company Law. At the same time, the responsibility mechanism and constraint mechanism should be established and completed. Independence of the supervisory board itself should be guaranteed so that it can impartially perform the duties and rights granted by law. - 49 www.emj-journal.org
Thirdly, the independent director system should be integrated. The independent director system originated in the United States, which refers to setting up independent director on the board in order to forming a balanced system with checking and balancing mechanism. Independent director undertakes only one position as an independent director, and has no relationship with the employed company or its major shareholders that might hinder him or her to make independent objective judgment. Independent directors shall be responsible for all the shareholders and the company. In 2001, the China Securities Regulatory Commission has issued Guidance for Establishing the Independent Director System of Listed Companies, according to the normative documents, the listed company shall establish the independent director system. The new corporation law was revised in 2005, article 123 stipulates clearly that listed company should set up independent director, which means independent director system has been established legally. Independent directors do not represent the investors (including large shareholders), also not on behalf of the company’s management. Relevant facts show that there is a positive correlation between the independent director system and the higher company value. Compared with those companies without independent director system, companies with independent directors run better. Investors of international institutions will increasingly need more independent directors contained in the company’s board of directors. As a matter of fact, independent directors play the similar role in the corporate government structure with the supervisory board, they exist for the purpose to supervise and constrain the board of directors and senior executives.
REFERENCES [1]
Simon Johnson, Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer. “Tunneling” [J]. The American Economic Review, May 2000,(90), pp. 22-27
[2]
S. Claessens, S. Djankov, L. H. P. Lang. “The Separation of Ownership and Control in East Asian Corporations” [J]. Journal of Financial Economics, 2000,(58), pp. 81-112
[3]
R. Rajan. “Insiders and Outsiders: The Choice between Relationship and Arms-length Debt” [J]. Journal of Finance, Sep 1992, Volume 47, Issue 4, pp. 1367-1400
[4]
J. Frank, C. Mayer. “The Ownership and Control of German Corporation” [J]. The Review of Financial Studies, Winter 2001 Vol. 14, No.4, pp. 943-977
[5]
M. Faccio, L. H. P. Lang. “The Ultimate Ownership of Western European Corporations” [J]. Journal of Finance Economics, Volume 65, Issue 3, September 2002, pp. 365-395 http://wenku.baidu.com/link?url=Pb4iWy2vT5ZWJ_n_Q9x9mecrNXkcMEVqYZFf4VT0AmHIWnlvhtN_rFpScZIiu96zAzXOqs dKxw0ds9nU4BjwYhuERjJEj9IA0UauZHgc3De
[6]
R. La Porta, F. Lopez-de-Silanes, A. Shleifer. “Corporate Ownership Around the World” [J]. Journal of Finance,1999(02), pp. 471-517
[7]
A. Shleifer, R. W. Vishny. “A Survey of Corporate Governance” [J ]. Journal of Finance, Volume 52,Issue 2, June 1997, pp.737783
[8]
Cubbin,Leech D. 1983, “The Effect of Shareholding Dispersion on the Degree of Control in British Companies: Theory and Evidence” [J]. Economic Journal, 1983(93), pp.351-369
[9]
Friedman, E. Johnson, S. , & Mitton, T. “Propping & Tunneling”, NBER Working Paper No.9949, September 2003, JEL No. G33, P12, K12, http://www.nber.org/papers/w9949
[10] Denis,Macconnell,2003, R. La Porta, F. Lopez-de-Silanes, A. Shleifer, R. Vishny. “Law and Finance” [J]. Journal of Political Economy, 1998,(106), pp. 1113-1155 [11] J. C. Coffee. “Privatization and Corporate Governance: The Lessons from Securities Market Failure” [J]. Journal of Corporation Law, 1999,(25), pp. 1-37, http://heinonline.org/HOL/LandingPage?handle=hein.journals/jcorl25&div=8&id=&page= [12] T. Kirchmaier, J. Grant. “Financial Tunneling and the Revenge of the Inside System” [Z],Working Paper, London School of Economics, 2005, http://eprints.lse.ac.uk/13324/ [13] Morck, R. , B. , Yeung , W. , Yu. “The Information Content of Stock Markets: Why Do Emerging Markets Have Synchronous Stock Price Movements?” [J]. Journal of Financial Economics, Volume 58, Number 1, 2000, pp. 215-260 [14] M. Bertrand, P. Mehta, S. Mullainathan. “Ferreting out Tunneling: An Application to India Business Group [J]. Quarterly Journal of Economics”, Volume 117, 2002, pp. 121-148 - 50 www.emj-journal.org
[15] V. Atanasov. “How Much Value Can Blockholders Tunnel? Evidence from the Bulgarian Mass Privatization Auctions” [J]. Journal of Financial Economics, ISSN 0304-405X, Vol. 76, No.1, 2005, pp.191-234 [16] R. La Porta, F. Lopez-de-Silanes, G. Zamarripa. “Related Lending” [J]. Quarterly Journal of Economics, Volume 118, No.1, 2003, pp.231-168 [17] Y. L. Cheung, L.H. Jing, P. R. Rau, A. Stouraitis. “Guanxi, Political Connections, and Expropriation: The Dark Side of State Ownership
in
Chinese
Listed
Companies”
[Z].
Working
Paper,
City
University
of
Hong
Kong,
2005.
http://www.researchgate.net/publication/245550151_Guanxi_Political_Connections_and_Expropriation_The_Dark_Side_of_State _Ownership_in_Chinese_Listed_Companies [18] C. Charumilind, R. Kali, Y. Wiwattanakantang. “Connected Lending: Thailand before the Financial Crisis [J]. Journal of Business”, Volume 79, No.1, 2006, pp.181-218
AUTHORS My name is Kun Deng. I was born in Baicheng City, Jilin Province, on May 9th, 1976. From September 1994 to July 1998, I studied in Tianjin Polytechnic University, where I got Bachelor Degree of Engineering, in Tianjin City. From September 2004 to July 2006, I studied in Nankai University, and obtained Master Degree of Economics, in Tianjin City. From September 2009 to July 2012, I studied in Peking University, and got Ph.D. Degree of Economics, in Beijing City. She had been working in Tristate Clothing (Shenzhen) Company Ltd. from July 1998 till May 2003 as a salesperson. Three years later, after she finished her graduate school, she worked in Guizhou Financial University as a lecture since July 2006. In May 2009, she left Guiyang and went to Beijing to finish her Ph.D. Degree. She entered China Zhongyuan Engineering Corp. (abbreviated as CZEC) in July 2012 and has been working there as economic manager till now. CZEC is located in No. B3, South Building Huayuan Rd., Haidian District, Beijing. Her previous publications are listed as following: 1). Small and Medium-sized enterprises financing and development of community bank—Revelation from the development of American community bank, Economic Perspective, 2011(8), pp. 150-153; 2). Analysis on efficiency of Small-Medium-Sized Enterprises financing pattern innovation in Industrial Cluster, Financial theory & practice, 2013(7), pp. 20-24; 3). Research on Risk and Countermeasures of BT project financing mode, Industrial & Science Tribune, Volume 13, (6), 2015, pp.209-211. Her previous research interests were involved with Small and Medium-sized enterprises financing, current research interest mainly focuses on company governance. Ms. Deng worked in CZEC as an economic manager.
- 51 www.emj-journal.org