“Siempre hay una forma de decir bien las cosas”

According to the OECD (2009b, 2011a, 2011b), the high level of ownership concentration makes Asian markets a fertile ground for tunneling through related party transactions, which now represents the biggest corporate governance challenge in the region. This is in line with previous studies that identified the proportion of shares of the largest shareholder as one of the most important determinant of poor governance in Asia (Claessens et al., 2000; Fan &

Wong, 2002). Similarly, many indices used by consultancy firms to appraise good governance include a measure of ownership dispersion as a key element (see for instance McKinsey & Company, 2002: 16; Standard & Poor’s, 2008: 6). While ownership concentration can address the principal-agent problem by reducing the information asymmetry and improving internal monitoring, it can also facilitate the appropriation of private benefits by the controlling owner (Shleifer & Vishny, 1997).

The diversion of cash flow by corporate insiders at the expense of external investors has been given various labels in the literature, including tunneling (Friedman et al., 2003), entrenchment (Claessens et al., 2002), self-dealing (Djankov et al., 2008), principal- principal conflicts (Jiang & Peng, 2011) and controlling-shareholder expropriation (Chen et al., 2011). These terms are used interchangeably in this text. Expropriation can take many forms, including the appointment of unqualified relatives, related party transactions (sales, loans, etc.), family controlled empire building or pyramid control. This can be achieved using direct or indirect means. Tunneling through related party transactions typically consists of a direct transfer of assets to another organization where the controlling shareholder has more income rights (Bertrand, Mehta, & Mullainathan, 2002; Jiang & Peng, 2011). Bae, Kang and Kim (2002) provide an example of indirect tunneling in South Korea, where a group-affiliated firm that conducts an acquisition often falls in value, while other firms in the group, including the parent company, gain value following the transaction. The minority shareholders of the acquirer see their cash flow used unproductively, while the controlling shareholder – the parent company – gains in value.

The attention given recently to this problem especially in China suggests that the balancing act at present requires the refinement of a conceptual framework to analyze controlling shareholder expropriation and the role of the state. China is a fertile ground for large shareholders to appropriate the cash flow of minority investors (Chen et al., 2009; Huyghebaert & Wang, 2012; Jiang et al., 2010; Wang & Xiao, 2011). Wu, Xu and Phan (2011: 108) suggest that the specificity of the institutional environment, with a strong state presence, weak financial protections and “the salience of non-economic stakeholder interests bonded with the economic interests of controlling shareholders” largely account for the prevalence of principal-principal problems in China. Firstly, most firms were privatized and

carry residual state ownership and employment relationships with the Party. This weakens the voice of external shareholders in the internal monitoring mechanisms (Opper & Schwaag-Serger, 2008). Secondly, Cheung, Rau and Stouraitis (2006) argue that the unreliability of judicial means to enforce shareholder rights limits the use of shareholder activism to protect the legitimate income rights of minority investors. Thirdly, the concentration of ownership (the average has been stable at 40% ownership by the top shareholder over the last 10 years) and the low floating ratio9 _{(the average increased from}

42% to 69% between 2005 and 2010) hinder the use of external control mechanisms such as hostile takeovers (Cheung et al., 2006).

To redress the low floating ratio, the state launched in April 2005 the split-share reform that sought to convert the non-tradable shares to be freely negotiated on the secondary market among investors. Prior to the reform, there was a split-share structure in which around two thirds of all shares at issue were non-tradable in the stock exchanges, mostly in the hands of state bodies at various levels. Making every state share of listed SOEs tradable was a big step in the process of privatization of state assets. While most shares are officially tradable since the completion of the reform in 2007, there are still serious limitations on transfers of large block holdings given the lack of market thickness and the industrial policy constraints in state- and SOE-controlled firms. There is also a three year lockup period post-IPO preventing owners from selling their shares. The resulting relatively low proportion of tradable shares has important consequences. Apart from limiting the potential disciplining effect that usually stems from healthy markets for corporate control, the constraints on share transfers dramatically damage the efficiency of the pricing mechanism on the market (Yang, Chi, & Young, 2011). Most importantly, owners of non-tradable shares cannot materialize the value of their asset by selling their shares on the market and are largely indifferent to price fluctuations (Chen et al., 2009). This provides an incentive to appropriate private benefits of control. In this context, given the low proportion of tradable shares supplemented by the high level of ownership concentration, controlling shareholders have the incentives

9 _{The floating ratio represents the proportion of a firm’s shares that are tradable on the}

and the capacity to initiate self-benefiting related party transactions, effectively tunneling cash flow out of the firm (Cheung et al., 2006).

The next section presents a detailed literature review about the most important factors identified in past theoretical and empirical work that influence the principal-principal problems in large listed firms in transition economies. This review is meant to theoretically ground the guiding propositions put forward in the following section.