We have followed the value-based approach to investigate a major corporate governance reform affecting publically listed firms in China. The regulations required that, in each firm, the owners of non-tradable shares (block shareholders) negotiate with the owners of tradable shares (minority shareholders) to determine the compensation paid to the latter for allowing non-tradable shares to trade on the stock market. If such an agreement is not obtained, the firm is forbidden to use equity refinancing in the future. The present study emphasizes the joint effect of value creation and value capture in determining the level of compensation, and finds that firms that expect to generate higher returns from future investments but face greater constraints in seeking non-equity-based financing tend to issue higher levels of compensation.
This joint effect is further moderated by factors related to investment returns and corporate governance. The empirical evidence lends strong support to theoretical predictions. This study has important implications for corporate governance in emerging markets, and the application of the value-based approach to corporate governance research in general.
Keywords: Value-Based Approach, Corporate Governance, Liquidity Reform, Bargaining, China *Contact: Nan Jia, Marshall School of Business, University of Southern California, Email: [email protected]sc.edu, Tel: 213-740-1045; Yongxiang Wang, Marshall School of Business, University of Southern California, Email: [email protected], Tel: 213-740-7650. Acknowledgements: We would like to thank Olivier Chatain, Gabriel Natividad, Victor Bennett, and Joanne Oxley for their helpful comments.
1. Introduction Value creation and value appropriation are central to the question of how economic actors cooperate in value-producing activities and then compete to divide the value created – a phenomenon that is fundamental to business strategy (MacDonald and Ryall, 2004; Gans, MacDonald, and Ryall, 2008; Chatain and Zemsky, 2011). To address this question, a rapidly growing body of research supports a value-based approach based on formal modeling (Brandenburger and Stuart, 1996, 2007; MacDonald and Ryall, 2004). The value-based approach has proven to be powerful tools for advancing our understanding of a wide range of topics in strategic management, such as market competition (MacDonald and Ryall, 2004; Gans et al., 2008), firms’ resource advantages (Lippman and Rumelt, 2003), buyer-supplier relationships (Chatain and Zemsky, 2007; Chatain, 2011; Jia, forthcoming), firms’ sustainable competitive advantages (Adner and Zemsky, 2006), social network positions (Ryall and Sorenson, 2007), and team organization (Bennett, 2012).
What has escaped researchers’ attention so far is to employ the value-based approach to advance our understanding of corporate governance issues. As one of the most investigated field in strategic management, corporate governance research focuses on how various governance structures align the incentives of all types of stakeholders (Daily, Dalton, and Rajagopalan 2003; Walls, Berrone, and Phan, 2012). Although theoretically speaking, inherent to many corporate governance issues is the tension between value creation and value capture, as stakeholders design corporate governance arrangements essentially both to incentivize all parties to work hard to increase the overall firm value, and to assist their competition with other stakeholders regarding sharing the value created (e.g., Tirole, 2001, Jensen, 2001), most strategy research has given overwhelming attention to the latter effect of competing over value appropriation, often called “stakeholder opportunism” (v. Werder, 2011).
In particular, the research of firm governance in emerging markets has predominantly placed opportunism and misappropriation of minority shareholders center-stage, and appropriately so, as rampant expropriation of minority shareholders generates inefficiencies and stalls economic growth (Morck, Stangeland, and Yeung, 2000; Morck, Wolfenzon, and Yeung, 2005). We believe, however, that stronger protection of minority shareholders also requires incorporating the value creation perspective, to more closely link corporate governance to obtaining cooperation of all shareholders in assisting firms’ business operation in the future, instead of treating the bargaining between stakeholders merely as a zero-sum game. The following example of a major corporate governance reform in China clearly shows how focusing on expropriation in a zero-sum game alone fails to reach the insights that can be achieved by the value-based approach. Prior to 2005, all firms listed in China’s stock market had two types of shareholders: owners of tradable shares and owners of non-tradable shares.
Both types of shareholders enjoy the same voting rights and the same cash flow rights. The only difference between these shareholders is embodied in their names: tradable shares can be traded freely on the stock market, while non-tradable shares cannot be traded on the stock market. Tradable shares are typically held by minority shareholders including individuals and institutional investors, and non-tradable shares are typically held by block shareholders, such as other business firms and the state. The 2005 reform was orchestrated by the CSRC (China Securities Regulatory Commission, China’s SEC-equivalent) to make all non-tradable shares tradable.
In it, the CSRC stipulates that, for every firm, the non-tradable shareholders negotiate with the tradable shareholders to determine the compensation received by the latter (from the former1) in exchange for enabling non-tradable shares to trade on the stock market. The failure to reach such an agreement prohibits the firm from refinancing in the stock market. Absent the value creation perspective, viewing this ownership reform as the shareholders competing only to appropriate a larger share of a fixed “pie” makes it very difficult to explain why powerful, large shareholders are willing to compensate minority shareholders. 2 Moreover, students of corporate governance in emerging markets are well versed with how block shareholders expropriate minority shareholders, and thus may expect limited compensation paid to the latter.
However, such explanations are incomplete. Through the lens of the value-based approach, we argue that the reform enables competition to create as well as to appropriate value. Reaching an agreement to reform the ownership structure increases a firm’s value in the future, as it provides the firm with access to equity refinancing to fund future investments. Therefore, non-tradable shareholders’ compensation for the minority shareholders in the reform should depend on their share of the firms’ expected returns from using equity refinancing to fund business operations in the future.
We show that, the compensation for tradable shareholders (minority shareholders) include some of the value that non-tradable shareholders (block shareholders) expect to gain from the firm’s future investment, because the compensation reflects how much minority shareholders could hold up the block shareholders from creating more value through future investments. Using a formal model and then corroborating it with empirical evidence, we show that non-tradable shareholders are more willing to compensate tradable shareholders to reform the ownership when the firm is more effective in investments but face greater constraints with regard to alternative financing.