Rent Seeking Incentives, Political Connections and Organizational Structure---Empirical Evidence fro

1 Rent Seeking Incentives, Political Connections and Organizational Structure: Empirical Evidence from Listed Family Firms in China Charles J. P. Chen China Europe International Business School Zengquan Li Shanghai University of Finance & Economics Xijia Su City University of Hong Kong Zheng Sun Shanghai University of Finance & Economics Current Version, May 2009 2 Rent Seeking Incentives, Political Connections and Organizational Structure: Empirical Evidence from Listed Family Firms in China Abstract In this study we examine the incentives for listed family controlled firms in China to establish political connections and their organizational structure as measured by shareholding concentration and composition of board of directors. We hypothesize and find that listed family firms are more likely to establish political connections when the local markets are less developed and the governments are more powerful in allocating economic resources. In particular, firms are more likely to build political connections when local governments suffer from severe budgetary deficits, when they tend to rely on discretionary charges and administrative penalties for raising revenues, and when they have more leeway in granting business subsidies. We also find that controlling shareholders of family firms with political connections tend to concentrate their shareholding and dominate the board of directors so that they can make deals with government officials in secrecy and enjoy the benefits exclusively among themselves. 3 1. Introduction Corporate political connections are widespread among the listed family controlled companies over the world (Faccio, 2006). A possible explanation for this phenomenon is that the controlling families need to seek private protection for their property rights when legal protection is insufficient or unreliable (Burkart et al.,2003; Morck and Yeung, 2004;Morck et al, 2005). Family control provides a tightly-knit corporate net-work within the family, which could ensure that benefits acquired through political connections are not diluted by sharing with outsiders as in wide-held firms. More importantly, family control can restrict access to sensitive information within the firm, a characteristic desirable to government officials who engage in rent-seeking activities. However, our understanding of the effect of the political connection on the organizational structure of family firms is constrained by a lack of empirical evidence. In a recent paper, Fan et al. (2007) document the existence of specialized assets, such as relationships with employees and banks, or assets jointly controlled by family members and/or co-founders., explains why ownership is concentrated for family firms. But they don’t directly measure the effect of political connections on the organization structure of these firms. To shed light on this issue, in this study we examine whether the political connections of listed family firms are endogenously determined by the insecure property rights and how political connections affect the firms’ organization structures. The school of property rights, starting with Coase (1960), has long stressed the interaction between property rights and the form of economic organizations, and the equally 4 important role of both individual owners and the state in the enforcement of property rights. Prior studies theoretically explain the emergence of concentrated ownership structures as a result of the inefficient legal system (Almeida and Wolfenzon, 2005; Bennedsen and Wolfenzon, 2000; Gomes and Novaes, 2005). Most of these studies implicitly or explicitly viewed the state as an instrument for providing the legal framework that enforces private contracts and facilitates economic transactions. However, the state is also viewed in some studies as an instrument for transferring resources from one group to another (see, among others, North, 1981; Shleifer and Vishny, 1998; Olson, 2000). The cross-country results of Acemoglu and Johnson (2005) suggest that it is the property rights institutions that have a first-order effect on long-run economic development. Therefore, it is necessary to consider the effects of possible government expropriation when examining the interaction between the property rights issues and the firm’s organizational structure. In economies with weak protection of property rights, the connections with politicians not only protect the firms from the expropriation by the government but also give firms preferential access to government subsidies, financing opportunities, and tax breaks (De Soto, 1989; Shleifer and Vishny, 1993; 1994). Based on property rights theories, we argue that the risk of expropriation by government agencies should be responsible for the prevalence of political connections at firm level. To ensure the success of rent seeking through political connections, the controlling family of a firm will prefer a centralized organizational structure, with which the family is the 5 sole decision maker, rather than a decentralized structure with which multiple large shareholders share the decision rights. The centralized organizational structure not only increases the homogeneity of interests, but also avoids the transfer of information about rent seeking among different decision makers. Using listed family (non-state-owned) firms from the two security exchanges in China, we first examine whether companies in regions where local governments have more incentives to seek rents are more likely to build political connections. We further examine how political connections affect companies’ ownership and board structure. We hypothesize and find that companies located in regions where local governments suffer from severe budget deficits, have a tendency to raise revenue from administrative fines and discretionary fee charges, and a tendency to grant fiscal subsidies are more likely to have political connections. Our findings suggest that the difference in the incentives for local governments to expropriate non-state-owned companies is an important factor for listed family firms to consider when deciding how much private protection for their property rights they should seek through political connections. We also find that the ownership and board structures of politically connected family firms are highly concentrated. This is consistent with the notion that a close-knit organizational structure allows the controlling shareholders to maintain a cozy relationship with government bodies and it also enables them to enjoy exclusively within themselves the benefits arising from political connections. 6 This study is directly motivated by two papers. The first one is Faccio (2006). Using 20,202 publicly-traded firms in 47 countries, she examined the determinants of political connections at country level, and found that politically connected firms are particularly common in countries with higher levels of corruption, with barriers to foreign investment, and with more transparent systems. Corporate political connections are less common when regulations set more limits on the behavior of government officials. Complementary to findings by Faccio (2006), we provide evidence that incentives for companies to seek political connections are influenced by regional differences in property rights protection within a country. We also show that the propensity for a regional government to expropriate non-state-owned firms has a direct impact on corporate decisions to establish political connections. Our study, thus, provides supplementary evidence on the interaction between legal protection, government behavior, corporate political connections, and firms’ organization structures. The second paper that also uses data from the Chinese securities market is Fan, Wong and Zhang (2007). They investigated the effects of having political connections on the corporate value and governance structure of 625 Chinese state-owned companies. They argued that property rules of China’s partial share issue privatization have created rent- seeking incentives for politicians that may hurt the performance and corporate governance of newly listed state enterprises. Their results indicate that the appointment of politically 7 connected CEOs does not enhance shareholder value but rather fulfills political goals of politicians. They focus on a sample of Chinese companies that are controlled by the government. The political connections in their study are imposed by the government rather than sought for by companies. Their study does not show under which circumstances companies have more incentives to seek political connections. To fill this void, the present study provides empirical evidence on incentives for seeking political connections and their effect on organizational structure of listed family firms in a transitional economy. Our study also contributes to the literature on the organizational structure of family firms. Prior studies have identified the threat of expropriation by the professional managers as the reason for the controlling family to retain its control rights over the firm (Bhattacharya and Ravikumar, 2001; Burkart et al., 2003). Our results show that corporate political connections also play am important role in determining the organization structure of family firms. The remainder of the paper is organized as below. Section 2 provides the institutional background. Section 3 develops research hypotheses. Section 4 defines the sample, variables and empirical models. Section 5 presents empirical results and Section 6 concludes the paper. 2. Institutional Background The institutional environment in China provides a rare opportunity for examining whether variation in the level of property rights protection within a country leads to 8 difference in the demands for political connections. For the past two decades, China has experienced remarkable economic growths through the process of transferring from a centrally planned to a market-oriented economy. To a large extent, the success of China’s economic reform is achieved by developing a private sector which is mainly composed of family firms. Non-state-owned companies accounted for 55.5% of national GDP in 1998, a significant increase from 22.4% in 1978. Meanwhile, state-owner enterprises’ (SOEs) share in the national GDP decreased from 77.6% in 1978 to 28.2% in 19981 1 Annual Statistics Book published by China Statistics Bureau. Note that the definitions of non-state-owned firms and SOEs were changed in 1998. As a result of this change, the percentage of non-state-owned (state- owned) companies’ share would have been even higher (lower) should the same definition be used. . Different from the East Europe where non-state-owned firms were mainly converted from state-owned companies, most non-state-owned companies in China are newly established by entrepreneurs. Members of the founding family usually maintain control of the firm after the establishment. Although, the private sector has become increasingly more important for the country’s national GDP growth, non-state-owned companies are still disadvantaged in China. Government policies, both at the central and local levels, dominate the allocation of resources, such as land, energy, electricity, water, licensing, and financial capital. In addition to suffering from a low priority in the government’s economic policies; non-state-owned companies are often subject to paying higher prices in obtaining resources. 9 Government monopoly over resource allocation is an institutionalized basis for its rent-seeking activities. In particularly, using their leverage over public resources and regulatory authorities local governments have been able to levy arbitrary fees and charges on, and even extort bribes from, local businesses. Obviously, the property rights of non-state- owned firms are not well protected by formal institutions including regulators and law enforcement agencies. An example of such discrimination is the government imposed restrictions over non-state-owned firms’ access to the capital market. At the end of 2004, among 1,329 listed companies, only 309 are controlled by the private sector, 192 of them are recently converted from listed state-controlled to non-state-controlled firms through takeovers. All of these 309 firms are family controlled and 160 (52%) of them are found to have political connections. This group of companies provide us with a rare opportunity for examining why so many non-state-controlled firms invest in political connections. The discrimination against non-state-owned companies is also reflected in debt financing through banks. The banking system is among the few industries that are still under the strict government control in China. The poor performance does not stop SOEs from continuously receiving a disproportionately large share of the credit extended by the main banks in China (Cull and Xu, 2005). A survey shows that non-state-owned companies have to raise capital through personal financing which usually accounts for 90.5% of their total capital, comparing with only a 4% borrowing from banks（IFC, 2000）. 10 Traditionally, China was a centralized country with most decision making authorities in the hands of the central government. The centralization of government power became a major obstacle at the early stage of economic reform which relies heavily on initiatives from lower levels. Although the central government refused to share with anyone its control power in the political arena such media, military, religion, and government personnel decisions, the economic decision rights have been greatly decentralized through the reform process (see Qian & Weingast, 1997 and Qian & Roland, 2000 for a discussion on the process and consequences of decentralization in the economic reform). As a result, the local governments have gradually built up their power over local businesses. With economic resources at their discretion, (e.g., licensing, fiscal subsidies, tax benefits, low-cost land, and waiver of enterprises’ liabilities), local governments can either grant preferential treatments to businesses or impose upon them additional fees and penalties. Various discretionary charges are imposed on companies and they can constitute a significant part of a company’s total operating expense. In some extreme cases, unjustified charges account for one third of non- state-owned companies’ operating expenditure (Chinese Business Daily, January 13, 2000). As such, avoidance of discretionary charges becomes an important issue for firms in regions where the local government has a tendency to rely on discretionary fee charges to supplement its insufficient tax revenue. 11 3. Research Hypotheses The property rights in any society are to be construed as supported by the force of etiquette, social custom, ostracism and formally legally enacted laws supported by the states’ power of violence or punishment (Alchian, 1965). The enforcement of property rights depends on power, and economies of scale in the use of violence frequently give a single agent, e.g. State, a monopoly over the legitimate use of violence. Since Coase (1960), the important role of government in delineating and enforcing private property rights has been recognized by economists. But the state is a two-edged sword: ‘the existence of a state is essential for economic growth; the state, however, is the source of man-made decline’ (North, 1981). Politicians use regulations to both create and extract rents from business activities (De Soto, 1990; Shleifer and Vishny, 1998). Faced with such threats, individuals will be deterred from production and investment, they will also attempt to take some countermeasures to preserve their property2 2 Stigler (1971) argues that government regulation is sought for by the industry and is designed to its advantage. McChensey(1987) also pointed that lobbying is used not only to gain monopoly rent but also to protect the enterprise’s assets from expropriation . . This type of attempts are particularly meaningful in emerging markets where due to a lack of effective law enforcement there exist both demands and possibilities for making deals to transfer rents between public officials and private entrepreneurs. Using a new dataset Hellman et al. (2003) find that a capture economy has emerged in may transition countries, where rent-generating advantages are sold by public 12 officials and politicians to non-state-owned firms. Political connections are found to be widely used by non-state-owned companies when the legal protection of property rights is unreliable or insufficient (Faccio, 2006). Incentives for seeking political connections vary not only across jurisdictions; they may also vary across regions within a country where regional economic and political developments are uneven. Based on the above discussion and the institutional setting in China, we propose a number of possible incentives below. Incentives for governments to levy discretionary charges on corporations may differ substantially across regions. Expropriation of non-state- owned companies is more likely to occur when local governments face significant budget deficits. In regions that have difficulties in attracting sufficient investment and retaining profitable businesses, government agencies may need to grant subsidies to companies in order to maintain local competitiveness. However, firms do not have an equal opportunity of obtaining this type of financial aid. As guidelines for granting government subsidies are often deliberately set to be vague and discretionary, firms with cozy relations with government officials have a much better chance of receiving the support. Therefore, given the level of expected cost, the expected payoff of political connections is much higher in regions where government agencies have a relatively larger amount of financial support at their discretion. Exactly for the same reason, it is expected that the incentives for firms to establish political connections will be higher in these regions. When receipts from discretionary charges and 13 penalties constitute a larger portion of local government’s total revenue, firms should have more incentive to build political connections as doing so may bring in significant cost savings. Extant literature suggests that governments in regions with less developed markets can influence the local economy more significantly and tend to have more controlling power over local companies (Qian & Weingast, 1997; Qian & Roland, 2000). This leads to our first hypothesis: 3 H1a: Ceteris paribus, corporate political connections are positively associated with the degree of regional market economy. . Based on the above discussion, we develop our first hypothesis as below: H1b: Ceteris paribus, corporate political connections are positively associated with the amount of regional government budgetary deficits. H1c: Ceteris paribus, corporate political connections are positively associated with the amount of regional government subsidies. H1d: Ceteris paribus, corporate political connections are positively associated with the amount of regional government discretionary charges and penalties. 3 This hypothesis developm