1. Tunneling, Propping and Expropriation: Evidence from Connected Party Transactions in Hong Kongby
Stephen Yan-leung Cheung
Department of Economics and Finance
City University of Hong Kong

2. Stephen Cheung, City University of Hong Kong
“...China Logistics Group (00217) to confess that millions of dollars has gone missing from its coffers.... The bulk of the cash is suspected to have vanished across the border.... A HK$ 200 million deposit paid out for the acquisition of Shanghai Pudong CNCC Logistics Development was missing... while the money left China logistics, it was allegedly never received by the vendor.”
South China Morning Post, 18 September 2002.
Stephen Cheung
City University of Hong Kong

3. Corporate Governance in Asia
Inefficient corporate governance
Reliance on family and state finance
Underdeveloped and illiquid investment market
Limited market for corporate control
Inadequate minority protection
Limited disclosure
Incentives aligned with core shareholders
“Insider
boards”
Concentrated ownership
Independence and performance
Capital market liquidity
Transparency and accountability
CORPORATE CONTEXT
Shareholder environment
INSTITUTIONAL CONTEXT
Source: McKinsey, 2001
Stephen Cheung
City University of Hong Kong

4. City University of Hong Kong
Introduction
Companies with concentrated ownership:
extract case by selling assets, goods, or services
obtain loans on preferential terms
assets transfer
dilute the minority shareholders’ interests
Stephen Cheung
City University of Hong Kong

5. City University of Hong Kong
Rules in Hong Kong
A connected transaction is defined as any transaction between a company (or any of its subsidiaries) and a connected person.
Connected persons are the listed firm’s (or the subsidiary’s) substantial shareholders, the directors (current directors or anyone who held this position at any time during the preceding 12 months), the chief executive and their associates, including any company where the above hold a substantial shareholding.
The definition also applies to any person co-habiting with the above and relatives (such as spouses, parents, step-parents, brothers/sisters, step-brothers/sisters, and in-laws).
Stephen Cheung
City University of Hong Kong

6. City University of Hong Kong
Rules in Hong Kong
For all transactions more than HK$10 million, in addition to a public announcement, the listed company must also notify the exchange by making a filing.
The minutes of the board meeting where the transaction was approved, noting also the views of the company’s independent non-executive directors, must be submitted to the exchange.
Within three weeks of such notification, the listed company must send a circular to shareholders providing full details of the transaction, including an opinion by an independent expert.
This is to be followed by approval of the transaction by shareholders in a general meeting, where any connected person interested in the transaction should abstain from voting.
Stephen Cheung
City University of Hong Kong

7. City University of Hong Kong
Objectives
What are the valuation effects of different types of connected transactions?
What are the characteristics of firms more likely to expropriate?
What should be done?
Stephen Cheung
City University of Hong Kong

8. City University of Hong Kong
Observations
1) There were 328 connected transactions worth at least HK$116 billion during The value of the median transaction was HK$ 106 million, representing 17.5% of firm’s market capitalization.
Stephen Cheung
City University of Hong Kong

9. Types of connected transactions
Asset acquisition
Asset sales
Equity sales
Trading relationships
Cash payments
Cash receipts
Subsidiary relationships
Takeover & joint-ventures
J V stake acquisition
J V stake sales
Stephen Cheung
City University of Hong Kong

10. City University of Hong Kong
Observations
2) 2 times more assets acquisition than asset sales; cash from listed companies to its controlling owners
3) 3.5 times more in providing cash assistance to third parties as opposed to receiving assistance
4) Terms are unfavorable (acquiring at a premium or selling at a discount) for most deals when information are available
Stephen Cheung
City University of Hong Kong

11. City University of Hong Kong
Observations
5) 15% did not disclose the value of transaction in filing.
6) 2.7% did not attach a report by independent financial advisors
7) 3.4% violated a previously granted waiver
8) 7% had taken place in the past but had not disclosed to the exchange
9) 4.9% constitute an outright breach of listing rules
Stephen Cheung
City University of Hong Kong

12. Case: Dickson Concepts International Ltd (I)
Background
It trades in luxury goods
Bvlgari watches
Lighters, pens
Jewellery, fashion products
Warner Bros. Products
The operations of the group mainly base in Hong Kong, Asia, UK, European countries and in North America.
Stephen Cheung
City University of Hong Kong

13. Case: Dickson Concepts International Ltd (II)
Unusual Transaction
On 30th December, 1999, the company entered into a consultancy agreement with a related company which is wholly controlled by the director himself.
It was said to be for the design, development, construction, and technological infrastructure of the “Cybermall”.
The fixed fee was HK$130 million.
Stephen Cheung
City University of Hong Kong

14. Case: Dickson Concepts International Ltd (III)
Market Reaction
It was clear to be a related party transaction
The director was being criticized for failure to disclose the agreement.
No records of work done for the consultancy
No approval initially from independent shareholders, but was later ratified by them.
The company argued that this was a service contract not a transaction.
Stephen Cheung
City University of Hong Kong

15. City University of Hong Kong
Results
Short-term,
Average of -3.4% during a period of 10 days after announcement
Sales of equity stake
-11.8%
Sales of assets
-6.4%
Acquiring of assets
-7.5%
Trading relationships
Selling JV
-6.1%
Cash payment
-2.5%
Stephen Cheung
City University of Hong Kong

16. City University of Hong Kong
Long term,
Average of -12.6% during a period of 12 months after announcements
Sales of assets
-21.9%
Trading relationships
-21.8%
Cash payment
-18.7%
Takeover & JV
-29.8%
Selling JV
-17.2%
Stephen Cheung
City University of Hong Kong

17. City University of Hong Kong
Blue: Size & MB adjusted CARs Red: Size adjusted CARs
Stephen Cheung
City University of Hong Kong

18. City University of Hong Kong
Returns are
negatively related to percentage ownerships by the main shareholders
negatively related to proxies for information disclosure
value of transaction
independent financial advisor
Big 5 as auditing firm
Stephen Cheung
City University of Hong Kong

19. City University of Hong Kong
likelihood of undertaking connected transactions is higher
ultimate owners can be traced to mainland China
likelihood of not disclosing the value of the deal and likelihood of violating the listing rules are higher for
Mainland China ownership
Concentrated ownership
Stephen Cheung
City University of Hong Kong

20. City University of Hong Kong
Variable of Corporate governance do not have any impact
audit committee
number of independent non-executive directors
CEO duality
Stephen Cheung
City University of Hong Kong

21. City University of Hong Kong
Discussion
The quality of independent non-executive directors
Information disclosure
Regulatory framework
Stephen Cheung
City University of Hong Kong

22. The Legal Approach to Corporate Governance
Stephen Cheung, City University of Hong Kong
The Legal Approach to Corporate Governance
The law and its enforcement are key mechanisms of investor protection.
When investors finance firms, they receive rights or powers in exchange. Without an ability to enforce rights, investors might end up with nothing.
Implication: Strong investor protection leads to deeper financial markets & better financing terms for firms.
How can expropriation be limited?
The principal method of such limitation is the protection of outside investors – whether shareholders or creditors – through the legal system, meaning both laws and their enforcement.
Although reputations and other mechanisms sometimes limit expropriation, law and its enforcement are central to understanding corporate governance arrangements around the world.
Potential shareholders and creditors are willing to finance firms to a significant part because their rights are protected by the law.
It is important to recognize that the shareholders and the creditors are much more vulnerable, and therefore much more dependent on the law, than either the employees or the suppliers, who remain continually useful to the firm and hence are at a lesser risk of being mistreated.
When investors finance firms, they typically receive certain rights or powers in exchange.
Creditors get the right to repossess collateral, or to force a reorganization of the firm, should certain conditions, such as the payment of interest or the adherence to particular covenants, be violated.
Shareholders get the right to vote on important corporate matters, such as the selection of directors.
All outside investors, whether shareholders or creditors, also have the right to obtain certain corporate information, and indeed many of their other rights can only be exercised when they have such information. For example, without access to accounting data, a creditor cannot know whether a debt covenant had been violated. Investors need these rights to get a return on their money. If they do not have these rights, the insiders do not have much of an incentive to repay the creditors or to distribute any dividends to the shareholders.
Investors need these rights to get a return on their money. If they do not have these rights, the insiders do not have much of an incentive to repay the creditors or to distribute any dividends to the shareholders.
All non-controlling investors -- large or small, shareholders or creditors -- need their rights protected. Dispersed minority shareholders require the right to be treated in the same way as other shareholders in dividend policies and in access to new security issues by the firm. The significant but non-controlling shareholders need the right to have their votes counted and respected. Even the large creditors -- the paragon of investors so powerful that they need relatively few formal rights -- must be able to seize and liquidate collateral, or to participate in the reorganization of the firm. Without an ability to enforce their rights, investors are likely to end up with nothing even if they hold claims to a significant fraction of the firm’s capital.
Outside investors rights are generally protected through enforcement of regulations and laws. Some of the crucial regulations are disclosure and accounting standards, which provide investors with some of the information they need to exercise other rights. Critical laws cover such rights of the shareholders as the ability to participate in dividends on pro-rata terms, to vote for directors, to participate in shareholders’ meetings, to subscribe to new issues of securities on the same terms as the insiders, to sue directors for suspected wrongdoing including expropriation, to call extraordinary shareholders’ meetings, and so on. Laws protecting creditors largely deal with bankruptcy procedures, and include measures enabling for creditors to repossess collateral, protect their seniority, make it harder for firms to seek protection from creditors in reorganization, and so on. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) present a selection of possibly important legal rules protecting shareholders and creditors, and document the availability of these rules in 49 countries around the world. They then create an anti-director rights (shareholder protection) and a creditor rights index for each of these countries.
In different countries, rules protecting investors come from different sources. They can come from company laws, security laws, bankruptcy laws, takeover and monopoly laws, but also from Stock Exchange regulations and professional bodies setting, say, accounting standards. Enforcement of laws is as crucial as the content of laws. In most countries, laws and regulations are enforced in part by regulatory agencies, such as Securities and Exchange Commissions, and in part by courts. There has been no work we are aware of documenting the costs and benefits of alternative modes of enforcement. As we show below, effective enforcement of some sort is crucial for the development of financial markets.
But what determines the control rights of the various participants in the firm, especially the investors?
Our view is that the legal rules and the effectiveness of their enforcement shape the actual rights of investors. When the rules -- such as the voting rights of the shareholders and the reorganization and liquidation rights of creditors -- are extensive and well enforced by regulators or courts, investors are well enough protected to part with their resources to finance firms. When the rules or their enforcement do not protect investors, corporate governance and external finance do not work well.
One way to think about this is that legal protection of outside investors makes the expropriation technology less efficient. When this technology is less efficient, the insiders expropriate less, and therefore their private benefits of control are smaller, and the total value of the firm is larger. Under these circumstances, firms can get outside finance on better terms. By shaping the expropriation technology, the law also shapes the opportunities for external finance.
The legal approach to corporate governance has emerged as a fruitful way to think about a large number of questions in finance, including those that opened the paper.
Company Law
Bankruptcy Law
Securities Law
Takeover Law
Courts & Regulators
Protect Shareholders & Creditors
Force timely disclosure of accurate information
Stephen Cheung
City University of Hong Kong

23. Stephen Cheung, City University of Hong Kong
Challenges Ahead
But more importantly, the evidence raised here suggests that there are 3 essential ingredients for the system to work in the long run:
Better investor rights in corporate laws, strong regulation on disclosure and accounting standards.
Regulations and laws that facilitate shareholder actions and private enforcement.
A well functioning judicial system which allows the functioning of financial markets and business transactions in general.
This paper describes a potentially useful way of thinking about corporate governance. Our starting point is legal protection of investors, both shareholders and creditors, through the legal rules and the mechanisms of their enforcement.
Empirically, strong investor protection is:
Associated with effective corporate governance, as reflected in valuable and broad financial markets, dispersed ownership of shares, and efficient allocation of capital across firms. Using investor protection as the starting point appears to be a more productive way to describe differences in corporate governance regimes across countries than some of the more customary classifications, such as bank- or market-centeredness.
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A simple model shows stealing by managers can make countries with weak legal systems vulnerable to the effects of a sudden loss of confidence. Countries with weakly enforceable
minority shareholder rights are particularly vulnerable. If such a country experiences even a small loss of confidence, outside investors reassess the likely amount of stealing by managers and adjust the amount of capital they are willing to provide. The result can be a fall in asset values and a collapse of the exchange rate.
In cross-country regressions, corporate governance variables explain more of the variation in exchange rates and stock market performance during the Asian crisis than do macroeconomic variables. This result does not mean that macroeconomic explanations are not important in the Asian crisis. While there is no agreement among economists about the relative importance of the current account, reserves, foreign debt, monetary policy and fiscal policy for emerging markets in , there is widespread agreement that macro policies were important.
An important implication of this approach is that leaving financial markets alone is not a good way to encourage them. Financial markets need some regulation -- whether by law, by agencies, or by market participants themselves. Improving this regulation is a difficult task. In part, the nature of investor protection, and of regulation of financial markets more generally, is deeply rooted in the legal structure of each country, and in the origin of its laws. Reform on the margin may not successfully achieve the reformer’s goals. In part, the existing corporate governance arrangements in many countries benefit the entrenched economic interests, such as the families that manage the largest firms in most places in the world. Corporate governance reform must address the opposition of these interests. Despite these difficulties, investor protection reform can bring significant benefits, and is politically feasible in some circumstances. It can take the form of opting into the more protective legal regimes, as well as the more radical change in the legal structure. The opportunity for such reform today is better than ever.
Countervailing political interests: institutional shareholders and creditors:
Made possibly by financial markets liberalization and integration
Larger influence during crisis (Thailand, Korea, Mexico)
Stephen Cheung
City University of Hong Kong

24. City University of Hong Kong
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Stephen Cheung
City University of Hong Kong