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In conclusion, although the findings from past research on Chinese firms are not all consistent, there are indications that the unique ownership structure and corporate governance of Chinese firms have impact on company performance. Overall, past research shows that the concentration of ownership, legal person shares and managerial shareholding have a positive effect on performance, while state shares have a negative effect on performance. Furthermore, the financial performance of Chinese firms as a whole deteriorates after listing, indicating that China’s corporatisation process has failed to improve corporate governance and management.
4. Hypothesis Development
Based on the findings of prior studies that examine corporate governance mechanisms prevalent in western firms (e.g., Beasley, 1996; Abbott et al., 2000; Sharma, 2004) and studies that examine the unique corporate structure and governance mechanisms in Chinese firms (e.g., Xu and Wang, 1999; Chen, 2001; Lin, 2001; Tian and Lau, 2001), this study identifies a set of governance mechanisms pertinent to Chinese listed firms and investigate their effect on corporate fraud.
Ownership Structure
Ownership structure, which is often defined as the concentration of share ownership and the proportion of shares held by different types of owners, is a key consideration in the design of governance mechanisms. The unique ownership structure of Chinese listed firms (with the state, legal person and private shares each accounting for nearly one-third of the shares subscribed) and the state dominance in ownership and control in the form of non-liquid, non-freely tradable state and legal person shares have significant implications for corporate governance in China.
Former SOEs which were under a single state authority have now been turned into JSCs and controlled by a number of state agencies and state-owned institutions with only a minor percentage of their shares being issued to the market for trading. According to Lin (2001), such a diversification of ownership has largely been a superficial exercise without any substantive change in the essential nature of ownership and control by the state and has, therefore, failed to achieve an improvement in corporate governance. This is because the diversification of shareholdings does not solve the principal-agent problem suffered by SOEs, JSCs’ predecessor. Under the former SOE system, ownership (property rights) belongs to everyone and to no one in particular. The state assumes the role as representative of the people and acts as the principal (owner) on behalf of the public in delegating day-to-day operational powers over enterprises to managers (agent). But the controlling authorities (e.g., central government line ministries and local governments) which exercise de facto ownership rights over SOEs, in reality do not bear any residual risks over the control and use of SOEs’ assets. Any residual claims (profits) or risks (losses) are socialised and simply passed on to the public at large. There is therefore a divorce between the bearing of residual risk and the exercise of control. This arrangement poses serious moral hazard problems as neither so-called principal (state controlling authorities of SOEs) nor enterprise management have adequate incentives to ensure the most efficient use of assets under their control. After corporatisation, the reallocation of SOEs’ control rights among various state bodies does not change the essential nature of the state ownership and control and, therefore, does not eliminate the moral hazard problems. Furthermore, the multiplicity of shareholding, according to Lin (2001), increases the separation of government from management and that equates to an increasing separation of principal from agent: i.e., increasing separation of ownership and control with informational asymmetries exacerbated. As a consequence, the corporate governance problem could become more serious.
According to Lin (2001), one significant problem of the predominance of state ownership is insider control and inadequate safeguards for outsiders. The company is run largely by and in the interests of the insidees to the potential detriment of outsiders and other stakeholders. Furthermore, the high degree of concentrated state ownership has restricted the capacity of China’s equity market to perform a disciplinary role in the governance of listed firms. This means that there is a weak – if not the absence altogether of a – market for corporate control, and listed firms are not exposed to any disciplinary incentives arising from takeover threats. The disadvantages of state ownership have been transposed to the capital market and are even more pronounced when the equity market comprises largely state-owned and controlled listed companies because there is an inherent and often unresolvable conflict between the role of the state as administrator and regulator and its role as a commercial entrepreneur and market player.
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