Comparative Corporate Governance in China

Political Economy and Legal Infrastructure

Guanghua Yu

• Publisher: Routledge
• Year: 2012
• eBook ISBN: 9781136713583
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

An insightful overview of the political, legal and social perspectives which inform corporate governance in China, this book examines the challenges of corporate governance faced by Chinese corporations and international corporations operating in China.

Unlike other texts that tend to focus solely on the board of directors and the takeover market, Yu has enlarged the scope of this study to cover both market forces and contractual mechanisms, providing readers with an extended and comprehensive discussion of the pertinent issues.

It explores a range of issues and their role in corporate governance models, including:

• 
  
  

• executive compensation
• takeover markets
• the securities market
• insolvency issues
• venture capital market

Examining the current climate and making the case that comparative corporate governance studies have significant policy implications for China's transitional economy, Yu has put together a book that is a valuable resource for students and those working in Asian business, corporate governance and commercial law.

Chapter 1

The relevance of
comparative corporate
governance studies

The Nature of the Problem

Emphasis on the problem of separation of control and residual claims can be traced back to Adam Smith. Smith highlighted the potential pitfalls of company structures that separated management from ownership. He stated that:

The directors of such companies being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.¹

He predicted that due to agency problems,² corporations that separated management from ownership would be unable to compete with organizational forms that allied ownership more closely with control. While he was correct in suggesting that serious agency costs would arise, he was wrong in predicting that the corporate form would fail. In their seminal work, Berle and Means examined the shareholding structure of modern US corporations and explained that the separation of ownership from control weakens the check on managerial power and makes convergence of interests between managers and shareholders more difficult.³

Sceptics such as Smith had noticed the potential problems resulting from the separation of residual claims and control in corporations. However, they neglected monitoring devices such as market forces and contractual mechanisms in alleviating such problems. It can be said that sceptics were either not interested in or have not paid any attention to comparative studies of monitoring devices. Recently, criticisms have been directed at these sceptics. Stigler and Friedland recognize the contribution of Berle and Means’ work in that the maximizing of the present value of a firm should be modified to take account of the separate interest of the management.⁴ However, they severely attacked the main theme of Berle and Means on two significant grounds. First, they claimed that empirical evidence available at the time when Berle and Means wrote their book did not establish that different types of corporate control had an effect on profits. Second, the data also revealed no relationship between the compensation of corporate executives and the type of control.⁵ However, I find that the analysis by Stigler and Friedland is far from satisfactory. With respect to the relationship between corporate profit and control, any static cross-sectoral analysis based on evidence on a particular point in time is simply unable to take into account the benefits gained from the growth of a corporation and the costs resulting from agency problems. I believe that ownership does matter.⁶ With respect to the relationship between remuneration of corporate executives and type of control, the data used is again static. The effect on the labour market is not considered.

Furthermore, perquisite consumption is not confined only to salaries or bonuses. Luxury offices or hotel rooms and other activities such as reduced efforts should also be included. Stigler and Friedland, however, were clearly right in their criticisms that Berle and Means failed to pay any systematic attention to the operation of the economic system.⁷ Within any economic system there exist monitoring devices which curb agency costs. Although Stigler and Friedland assumed the existence of such monitoring devices, they did not examine the economic implications of these monitoring devices.

Demsetz and Lehn launched similar attacks on Berle and Means’ findings.⁸ Their analysis on the separation issue is simple. They argue:

If difference in control allows managers to serve their needs rather than tend to the profits of owners, then more concentrated ownership, by establishing a stronger link between managerial behavior and owner interests, ought to yield higher profit rates.⁹

However, they did not expect to find such a relationship and their view was confirmed by the data they collected.¹⁰ I think that Demesetz and Lehn did not satisfactorily refute the thesis of Berle and Means. The finding that there is no correlation between the profit rate and ownership concentration does not mean that agency costs are not high in management-controlled corporations. As Demesetz and Lehn pointed out, the higher costs and reduced profits that would be associated with loosening of owner control should be offset by lower capital acquisition costs or other profit-enhancing aspects of diffused ownership if shareholders choose to broaden ownership.¹¹

In the same article, Demsetz and Lehn also argued that share ownership concentration levels are inversely related to the aggregate size of the firm.¹² This relationship holds because as the value-maximizing size of the firm increases, the cost of acquiring a control block will also rise, deterring control accumulation. In addition, when the benefits from control transactions are smaller than the benefits resulting from share diversification, the latter will be chosen. It seems that Demsetz and Lehn did not consider comparative studies of monitoring devices. Otherwise, they may have found that their conclusion could not be applied to Germany and Japan. Roe pointed out that most of the biggest non-financial corporations in Japan and Germany are controlled by financial institutions.¹³ I believe that comparative studies of monitoring devices guided by agency theories can explain the determinants of different monitoring devices in different places.

Despite the costs in the formation and growth of corporations, the economic functions of modern corporations indicate that the formation and growth of corporations also give rise to economic benefits. Under the conditions of shareholder profit maximization, the benefits resulting from the formation and growth of corporations include reduction of transaction costs,¹⁴ risk diversification,¹⁵ team work,¹⁶ special knowledge of managerial experts,¹⁷ and economies of scale.¹⁸

In this chapter, I assume these benefits (without proving them as the benefits connected with the formation and growth of corporations) normally exceed the agency costs. Deviation may occur when the management of a corporation makes mistakes or pursues its own interests in expanding the size of corporations. Competition between different sized corporations, however, sifts out the more efficient enterprises.¹⁹

My main purpose is to examine how monitoring devices such as market forces and contractual arrangements may reduce agency costs resulting from the separation of control and residual claims and also those agency costs connected with loan transactions and bond issues. Building on Jensen and Meckling’s work, I discuss agency costs in section two. Then I will canvass the roles of various monitoring devices in alleviating agency costs. While there is a wealth of literature on agency theories, the literature on agency costs resulting from the separation of control and residual claims and the literature on agency costs related with loans and bond issues has been developed along separate lines. Although a particular method of financing determines the corresponding monitoring devices, a monitoring device may serve the purpose of controlling both the agency costs of equity financing and of debt financing. As the methods of financing corporate decisions through either debt or equity are not mutually exclusive, monitoring devices dealing with agency costs of both debt financing and equity financing could coexist.

In section three, I will compare special features of monitoring devices in Germany, Japan, the USA and Hong Kong. As monitoring devices can simultaneously affect both agency financing and debt financing, I conclude that monitoring devices in these countries are not static and countries can learn from each other, although it should be borne in mind that the adaptation of foreign laws is subject to local political and economic conditions. I will then demonstrate in section four the relevance of comparative studies of monitoring devices for China’s economic reform. In contrast to Roe, I believe that comparative studies of monitoring devices have significant policy implications.

Agency Costs and Monitoring Devices

Jensen and Meckling define an agency relationship in equity financing as a contract under which one person (the principal) engages another person (the agent) to perform some services on its behalf which involves delegating some decision-making authority to the agent.²⁰ In the corporate law context, the principals refer to shareholders and the agents refer to directors and managers. If the principals and agents are rational, there is good reason to believe that the agents will not always act in the best interests of the principals. This has been well documented by Berle and Means.²¹ The divergence of interests will cause three types of costs – the monitoring expenditures by the principal, the bonding expenditures by the agent and the residual loss.²²

The monitoring expenditures by the principals refer to the costs incurred by the principals to provide incentives for the agents through contract and to monitor the activities of the agents. The bonding costs are necessary because it is to the benefit of the agents to spend resources in order to guarantee that they will not take certain actions which will harm the principals or to ensure that the principals will be compensated if the agents take such actions.²³ The agents benefit from these expenditures as these costs serve the purpose of signalling to the principals that the agents are relatively good and reliable. Inefficient managers and directors are more likely to fail in corporations. Hence, it is less likely for them to make these promises. Therefore, bonding costs tend to alleviate the ex ante adverse selection problems.²⁴ The residual loss is inevitable as it is generally impossible for the principals or the agents to ensure that the agents will make optimal decisions from the principals’ viewpoint at zero cost. Agency costs of equity financing may include lapses in managerial competence or effort, managerial entrenchment or empire building and excessive managerial compensation or perquisite consumption.

Similarly, there are agency costs in debt financing. The agency costs associated with the existence of debt claims for the corporation include the opportunity wealth loss caused by the impact of debt on the executives by the bondholders and the bond issuers or loan users, and the bankruptcy and reorganization costs.²⁵ The opportunity wealth loss refers to wealth transfer transactions that reduce efficiency. When the debt/equity ratio is very high, bond issuers and borrowers will have a strong ex post incentive to engage in risky activities which promise very high payoffs if successful but have a very low probability of success. If they do well, the bond issuers or borrowers capture most of the gain. On the other hand, if the riskier projects turn out badly, the creditors or bondholders bear most of the costs.²⁶

Specifically, at least four types of wealth-redistributing transactions can be identified.²⁷ First, firm assets of the debtor or bond issuer are distributed to shareholders of the debtor or bond issuer. The most explicit form of wealth transfer is the distribution of firm assets to shareholders after debt has been issued. The distribution of firm assets to shareholders includes the payment of dividends or the repurchase of stock. The removal of assets decreases the expected value of the firm at maturity and devalues existing debt.

Second, wealth transfer transactions may be carried out by the subsequent issuance of debt of equal or higher priority. As the issuance of new debt of equal priority increases the amount of competing claims, the value of existing debt is reduced if the use of the new capital does not increase the present expected value of the firm at maturity by at least the amount of the new debt.²⁸ Existing creditors are also worse off if secured debt of higher priority is issued as this reduces the claims of the existing creditors if the new debt is not properly used.

Third, wealth transfer may take the form of increasing the risk of the assets of the borrower. After the issue of debt, debtors have the opportunity of switching to a riskier investment strategy that enables shareholders of the debtors to benefit from all the upside risk and participate in the downside risk only to the extent of their investment. In the transactions, creditors or bondholders must share in the downside risk up to the amount of their investment but cannot share in the upside benefits beyond the face value of their debt. The frequency of these wealth transfer activities increases when the debtor is close to insolvency. Finally, debtors may gorge valuable investment opportunities. Managers of the debtor have incentives to pass up valuable investment opportunities when profits from the investment would accrue to debt holders and not to their shareholders.²⁹

Bonding costs refer to the promises made by the contractual parties to reduce adverse selection problems and moral hazard problems. For instance, the provision of firm-specific assets as security to the creditor is a type of bonding cost. In the case of the debtor not being able to pay the due debt, some valuable assets of the firm may be lost. Monitoring costs refer to the costs incurred by the creditor to check whether the debtor has misbehaviours which violate any contractual provisions and to check the management of the debtor’s business. Since management is a continuous decision-making process, it will be almost impossible to completely specify the conditions without having the bondholders actually perform the management function.³⁰ In other words, unnecessary detailed provisions and continued monitoring of the debtor may result in some efficiency losses.

Bankruptcy costs include reduced claims, legal and liquidation or reorganization fees. W...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Dedication
• Contents
• Preface
• 1. The relevance of comparative corporategovernance studies
• 2. The problem with the transplantationof Western law
• 3. The proper role of government in buildinga venture capital market
• 4. The case against uniformity in corporategovernance
• 5. The regulation of executive compensation
• 6. Towards a functional approach to comparative corporate governance studies
• Notes
• Index