Discussion of “Intra-Industry Effects of Corporate Scandal Announcements: Evidence from China” Donghui Wu School of Accounting & Finance The Hong Kong Polytechnic University July 2010

1 PetroChina The world’s most valuable company (FT500 ranking) It is critical to understand Chinese market and Chinese firms. The YZZ study: – The contagion effect of corporate frauds on firm value in China.

2 The contributions of YZZ A methodology issue in the fraud literature: the identification problem –Only the detected frauds can be observed. –Some “non-fraud” firms could have committed frauds but have not been caught. This study evaluates the probability of undetected frauds. –The contagion effect: negative market reaction to non-fraud peer firms. –This provides an estimate of the probability of a fraud occurrence, as perceived by investors.

3 The contributions of YZZ (Cont.) YZZ also study the relationship between contagion effect and CG. –The evidence sheds new light on the value of CG. Traditional approach: Performance (e.g., Tobin’s Q) = f(CG). –Correlated-but-omitted-variable problem The short-window study (CAR [-2,+2] ): easier to show the causality. The setting of corporate frauds: a specific mechanism for CG to improve firm value.

4 Institution environment and frauds of Chinese listed firms China’s transitional economy –Concentrated ownership structure An ultimate controlling shareholder. –Tight government control of capital market The listing process and subsequent capital raising are controlled by the CSRC. Accounting-based regulations in the IPO, SEO and delisting decisions.

5 Institution environment and frauds of Chinese listed firms (Cont.) –Weak market mechanisms and investor protection Lack of market for corporate control. Limited monitoring role played by institutional investors and financial analysts. Poor enforcement of law and regulations. –Poor information environment High level of stock price synchronicity (Morck et al., 2000; Jin & Myers 2006). Chinese firms are able to suppress bad news (Piotroski et al., 2010).

6 The nature of frauds US firms (see Coffee, 2005): –Dispersed ownership structure – Type I agency problem. –Aggressive use of equity compensation. –Creating incentives for short-term financial manipulation. Chinese firms –Concentrated ownership structure – Type II agency problem. –Controlling shareholders are more interested in diverting resources from listed firms under their control. –Moreover, they have incentives to manage earnings to meet the accounting benchmarks set by the regulators.

7 The contagion effect of frauds On the one hand, the poor information environment suggests strong contagion effect. –Investors get new information to reassess the probability of frauds in the peer firms. On the other hand, the poor institutional environment suggests week contagion effect. –Investors have anticipated that frauds are prevalent. –The announcements of frauds confirm their prior belief and thus do not convey much new information. Therefore, how strong the contagion effect is should be an empirical issue.

8 The impacts of CG on the contagion effect On the one hand, the weak country-level institutions suggest that firm-level CG plays an important role. –Fan & Wong (2006): the importance of auditing when country-level institutions are weak. On the other hand, firm-level CG cannot be effective without the support of country-level institutions. –Doidge et al. (2006): countries matter so much for the effectiveness of CG. Again, this is an empirical issue.

9 Interpretation of empirical findings The main findings on the contagion effect (CAR [-2,+2] ) –Fraud firms: -5.66% –Peer firms: -0.48% Is the effect strong? –For fraud firms, the effect is not strong, compared with the US evidence. –For peer firms, the effect is relatively strong. Comparable with the US evidence (Gleason et al. 2008). The probability of similar but undetected frauds is: 0.48%/5.66% = 8.5%. –Investors are indeed concerned with the possible problems in the peer firms!

10 Interpretation of empirical findings (Cont.) Financial vs. non-financial frauds –Fraud returns:-5.34% vs % –Contagion returns:-0.30% vs % Why weak reaction to financial frauds? –The Type II agency problem leads to more serious non-financial frauds. –Accounting information is less important in China in contracting or informing investors (Hung et al., 2008). –Or the accounting problems have been anticipated by the market. e.g., ROA in (0, 1%] indicates earnings management to avoid delisting regulation.

11 Interpretation of empirical findings (Cont.) The post-announcement drift (CAR [+3,+60] ) –Fraud firms: -4.64% –Peer firms: -2.16% Why the drift? –The market is not so efficient? It is important to examine whether the drift is consistent with the hypotheses.

12 Interpretation of empirical findings (Cont.) CG and contagion effect –Some CG variables are statistically significant in explaining the contagion effect. –However, economically, not so significant. –The significance can be evaluated by: Dummy variables – β*1 Continuous variables – β*1 std. dev. Region institutionFirm CGIndustry competition GDP: -0.20%OWN: -0.20%HHI: 0.17% PCT_2: 0.18%DIFF: 0.08% BIG: 0.20%MKTSIZE: 0.17% ENTRYCOST: 0.06%

13 Interpretation of empirical findings (Cont.) Why these variables are not so significant in economic sense? –Theoretically, it could be due to the unimportance of CG in a weak institution environment. –Empirically, it could be due to research design.

14 Research design issues Intra-industry contagion effect –In the first place, we assume homogeneity within industry, including CG. –However, this also suggests a lack of variability in the key variables of interest. The clustering of fraud events in time. –The effect will be weaker for the same type of frauds that repeat. This is exactly due to the contagion effect of early frauds.

15 Research design issues (Cont.) Different types of frauds –Some frauds may not cause market reaction. e.g., failure to disclose information on time. This may not have any contagion effect since other firms have disclosed information on time. –Cases investigated by the CSRC could be more serious than the reprimand cases by exchanges. –Frauds in 2001 (“year of regulation”) could be associated with weaker reaction.

16 Some other suggestions What are the determinants of frauds? –Chen et al. (2006 JCF) study the CSRC enforcement actions. Board independence, CEO tenure, board meeting frequency, and CEO duality explain the likelihood of frauds. But not ownership characteristics or regional development level. –It would be useful to analyze the probability of frauds and CG, and then test the contagion effects accordingly.

17 Some other suggestions (Cont.) Intra-industry –The rationale: firms in the same industry share some common fundamentals. –Is this true? Extending to other forms of contagion effect –Firms controlled by the same shareholders (e.g., Shanghai government). –One scandal (e.g., CHEN Liangyu) may reveal the problems of the shareholder.