Disproportional ownership structure and pay–performance relationship: Evidence from China's listed firms

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Abstract

This paper examines the impact of ownership structure on executive compensation in China's listed firms. We find that the cash flow rights of ultimate controlling shareholders have a positive effect on the pay–performance relationship, while a divergence between control rights and cash flow rights has a significantly negative effect on the pay–performance relationship. We divide our sample based on ultimate controlling shareholders' type into state owned enterprises (SOE), state assets management bureaus (SAMB), and privately controlled firms. We find that in SOE controlled firms cash flow rights have a significant impact on accounting based pay–performance relationship. In privately controlled firms, cash flow rights affect the market based pay–performance relationship. In SAMB controlled firms, CEO pay bears no relationship with either accounting or market based performance. The evidence suggests that CEO pay is inefficient in firms where the state is the controlling shareholder because it is insensitive to market based performance but consistent with the efforts of controlling shareholders to maximize their private benefit.

Introduction

In recent years two strands of research on the effect of ownership structure on pay–performance relationships have begun to emerge. The first focuses on the effects of cash flow rights and divergence between control rights and cash flow rights (excess control rights) on CEO pay (Masulis et al., 2009, Barontini and Bozzi, 2010). With US dual-class firms, Masulis et al. (2009) find that the divergence between an insider's control and cash flow rights has a positive effect on CEO pay, while from a sample of Italian listed firms, Barontini and Bozzi (2010) acknowledged that there is a negative effect. The second strand focuses on the effects of an ultimate controlling shareholder's type on the pay–performance relationship, particularly between state and non-state owned firms in transition economies such as China. For example, Kato and Long (2005) find that state ownership weakened the pay–performance relationship. Firth et al. (2006b) find that distinct types of controlling shareholders have different impacts on the use of incentive pay for CEOs, and they provide evidence that CEO pay is weakly related to firm performance in firms whose controlling shareholder is either the central government or a private owner. We extend their research by explicitly examining how a controlling shareholder's type, cash flow rights and excess control rights shape CEO pay and the pay–performance relationship.

Several studies find that the wedge between cash flow and control rights affects firm value (Claessens et al., 2002, Lemmon and Lins, 2003, Laeven and Levine, 2008, Gompers et al., 2010). Indeed through a common practice of ownership concentration and pyramid structure, controlling shareholders in emerging markets can exercise control through voting rights despite having relatively small proportional cash flow rights. These excess control rights give controlling shareholders an incentive to expropriate the wealth of other investors and pursue their own interests, which are often diametrically opposed to those of minority shareholders (Chen et al., 2011). The issues regarding the expropriation of minority shareholders are especially relevant in economies with weak legal protection or poorer governance standards (La Porta et al., 1999, La Porta et al., 2000, Johnson et al., 2000, Peng et al., 2011). Conflicts between the largest shareholders and minority shareholders are particularly severe in transition economies where the ownership is highly concentrated and investors lack legal protection (Shleifer and Vishny, 1997, Lin et al., 2003). The general consensus is that a disproportional ownership structure allows for easier expropriation of the wealth of minority shareholders, which results in a firm's lower value. Fan et al. (2011) further suggest that the cost of expropriation may ultimately be born by the controlling shareholders and that they would need to devote substantial resources to their expropriation activities. However, the question of whether the controlling shareholder's excess control rights affect CEO pay remains unexplored in the context of disproportional ownership economy. CEO compensation is essential to provide management incentive, which is not necessarily consistent with the interest of minority shareholders.

Aligning executive interests with those of shareholders is an important governance mechanism (Jensen and Murphy, 1990). In economies with concentrated ownership, the largest shareholders are often in charge of setting CEO compensations. The impact of ownership concentration and excessive control on executive incentives remains contradictory. Murphy (1999) suggested that the largest shareholders have strong incentives to directly monitor managers by relating CEO pay to firm performance. On the other hand, the separation of control and cash flow rights is able to adversely affect the pay–performance relationship, since the largest shareholders extract their private benefits by setting CEO compensation schemes unrelated to the wealth of minority shareholders but to the controlling shareholder's private interest. To help understand these questions, we use the unique Chinese context1 to examine the effect of ownership structure, specifically cash flow rights and control rights of the ultimate controlling shareholders, on the pay–performance relationship.

China's economic transition follows a path of partial privatization, in which the state retains control over many SOEs by floating only a small percentage of shares to the public. It does this through creating a long principal-agent chain, a significant pyramid structure, and cross-shareholdings of ownership. As a result, the state controlling shareholders have substantial control rights in excess of their cash flow rights. At the same time, many privately controlled firms were also listed in the capital markets in China through initial public offerings (IPOs) along the development of these Chinese markets after 2001.

State controlled and privately controlled firms have different operating objectives due to the nature of their ownership and are also subject to different regulations. It is argued that state controlled firms operate with multiple objectives that vary between maximizing the wealth of shareholders, maintaining urban employment levels, and controlling sensitive industries (Clarke, 2003). Fan et al. (2011) also argued that state ownership, which is often non-tradable or not freely-transferrable, can have a significant impact on managerial incentive schemes. Therefore, it is important to distinguish between state and private-controlled firms because they may intend to use different incentive schemes.

However, due to the complex ownership structure of state controlled firms, it is also important to distinguish among state controlled firms. State controlling shareholders may belong to different state owned entities and government agencies and each of them may have different objectives and therefore desire to adopt different pay schemes. Therefore we classified state controlled firms into two categories based on their ultimate controlling shareholders: state assets management bureaus (SAMBs), and state owned enterprises (SOEs). SAMB is a government agency responsible for managing and controlling state owned assets. In SAMB controlled firms, CEOs work as representatives of the government, so their pay scheme may not be based purely on economic performance. In contrast, the publicized goal for SOE controlled firms is to maximize the firm's value and incentivize management.

Historically, most general managers of state controlled firms worked as bureaucrats and were paid according to the civil service pay scale. Since 1985, China introduced wage reform and other economic reforms in state controlled firms to improve the management compensation scheme. In 2000, the Ministry of Labor announced that CEO payment in state controlled firms should be linked to a firm's economic performance (The Ministry of Labor, 2000). However, this did not provide sufficient incentive as firms still operated under the previous system where profits and wages were being redistributed by the state (Yueh, 2004). With the establishment of two stock exchanges in the early 1990s and the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC) in 2003, many state controlled firms were restructured and listed on the two stock exchanges. Since 2003, many regulations have been promulgated by SASAC to evaluate SOE performance and align this with CEO pay. Specifically, SASAC issued ‘Interim regulations on the evaluation of the top executive operating performance’ in SOEs affiliated to the central government (SOECGs) in 2003, which clearly stated that the top executive pay should be aligned to total profits and sales and described how to evaluate executive performance.2 In 2006 and 2010, SASAC updated this regulation by adding some extra rules such as the punishment of top executives when they were underperforming. Obviously, by putting these regulations into practice, SASAC has decreed that profitability should be the primary measure of firm performance to which CEO pay should be linked. Meanwhile, to curtail CEOs from expropriating shareholder wealth through excessive perks, SASAC also promulgated ‘Instructions on regulating top executive ‘on-job’ consumptions in SOECGs’ in 2006.3

These reforms and regulations of executive compensation in SOE controlled firms are largely aimed at aligning the interests of shareholders and management. Several studies document a positive pay–performance relationship in both SOE and privately controlled firms but not in SAMB controlled firms (Kato and Long, 2005, Firth et al., 2006b, Firth et al., 2007). These results confirmed that the goals of these reforms in SOE controlled firms and CEO compensation have been achieved to some extent.

In China's weak corporate governance environment, the largest shareholders have strong incentives to monitor managers and operations as their concentrated cash flow rights help overcome the free ride problem. However, if control rights exceed cash flow rights, controlling shareholders are likely to pursue their own interests and may seek to expropriate minority investors by tunneling, related party sales, and transferring profits out of the company for personal gains (Johnson et al., 2000, Fan et al., 2011). Such conflicts of interest between the largest shareholders and minority shareholders will hamper the application of performance based pay incentives (Wang and Xiao, 2011). Therefore, the largest shareholders' cash flow rights and excess control rights may have conflicting effects on the pay–performance relationship. Our first hypotheses states that:

  • H1a

    Cash flow rights have a positive effect on pay–performance relationship.

  • H1b

    Excess control rights have a negative effect on pay–performance relationship.

Many controlling shareholders of China's listed firms are state-owned entities or government agents, and state held shares are not tradable on the stock exchanges5. As a result, state shareholders have an incentive to set CEO pay based on accounting-linked performance indicators, since to maximize free cash flow, they either receive cash remittance or can expropriate other investors that have more resources available. Therefore, market based indicators such as stock return often have no direct link to a controlling shareholder's wealth. Accordingly, we argue that state shareholders emphasize maximizing profits rather than shareholder value. In contrast, since shares in privately controlled firms held by the largest shareholders can be freely traded, private investors are more concerned about market performance. Therefore, we formulate the following hypothesis:

  • H2a

    Cash flow rights in state controlled firms have a positive effect on accounting performance based pay–performance relationship, while cash flow rights in non-state controlled firms have a positive effect on market performance based pay–performance relationship.

  • H2b

    Excess control rights in state controlled firms have a negative effect on accounting performance based pay–performance relationship, while excess control rights in non-state controlled firms have a negative effect on market performance based pay–performance relationship.

In China under SASAC, SOE controlled firms are directly and ultimately controlled by central and/or local governments. It is mandatory that state owners receive cash flows, including profits and dividends, because shares of SOEs are often not tradable unless approved by the CSRC and the selling price is only at book value (Xu, 2003). Since 2003, CEOs of SOE controlled firms have been evaluated according to a combination of annual performance measures such as return on assets (ROA) and return on sales (ROS). We therefore hypothesize that:

  • H3a

    Cash flow rights have a positive effect on accounting based pay–performance relationship in SOE controlled firms.

  • H3b

    Excess control rights have a negative effect on accounting based pay–performance relationship in SOE controlled firms.

SAMBs4 are the state agencies that hold non-tradable shares on the market. They do not have cash flow rights from these shares and payouts often have to be remitted directly to different levels of governments (Firth et al., 2006b). The objectives of SAMB controlled firms are to carry out the instructions of the central or local governments and to maintain local employment levels rather than maximize the value of a firm. In most instances CEOs in SAMB controlled firms are officials from the government, with little or no professional background, no rights to select other top executives, and no responsibility for economic consequences (Zhang, 1998). We therefore hypothesize the following:

  • H4

    Cash flow rights and excess control rights have no effect on pay–performance relationship in SAMB controlled firms.

Our results indicate that CEO pay in SOE controlled firms is related to firm accounting performance (return on assets and return on sales), while CEO pay in privately controlled firms is related to market performance (stock return). However, there is no relationship between CEO pay and firm performance in firms controlled by SAMBs. Our regression results show that the cash flow rights of the largest shareholders enhance accounting performance related pay schemes in SOE controlled firms and improve market performance related pay schemes in privately controlled firms. However, the separation between control rights and cash flow rights shows negative entrenchment effects by significantly reducing the pay–performance relationship in both SOE and privately controlled firms. We also find that cash flow rights in SAMB controlled firms do not appear to affect the pay–performance relationship, which confirms the consensus that these firms do not really have cash flow rights because they must remit earnings back to their superiors (Firth et al., 2006b).

We have made two substantial contributions to the literature. First, our research not only sheds light on how cash flow rights and excess control rights affect CEO pay, it also submits new evidence on how cash flow rights and excess control rights affect the pay–performance relationship. Cash flow rights have a positive incentive effect on the pay–performance relationship while excess control rights have a negative entrenchment effect. Second, our study furthers the understanding that different performance based pay schemes are used between SOE controlled firms and privately controlled firms. Cash flow rights and the divergence between control rights and cash flow rights influence pay–performance relationship across firms with different types of ultimate ownership. Our evidence suggests that CEO pay in firms with SOEs as the controlling shareholders is determined by accounting based performance but is not sensitive to market based firm performance. This is consistent with the private benefits of controlling shareholders, as the CEO pay scheme aims to maximize accounting performance in order to extract greater cash flows.

The rest of the paper proceeds as follows: Section 2 reviews the relevant literature; Section 3 outlines the data and methodology; Section 4 discusses the empirical results; and Section 5 presents the conclusions.

Section snippets

Literature review

The separation of ownership and control by the largest shareholder has been researched extensively. For example, La Porta et al. (1999) argued that the ultimate controlling shareholders often use a pyramid structure and cross shareholding to obtain control rights in excess of their cash flow rights. With a sample of 1301 publicly traded corporations in eight East Asian countries at the end of 1996, Claessens et al. (2002) provided important evidence that cash flow rights have a positive

Sample

We compile data from firms listed on the Shanghai Stock Exchange and Shenzhen Stock Exchange between 2002 and 2007 because information on cash flow rights and control rights has only been available since 2002. We obtain firm characteristics from the Chinese Stock Market Accounting Research (CSMAR) database and the data on managerial compensation, board, and ownership structure from the SinoFin database. Both databases have been used in past studies of Chinese listed firms (e.g., Kato and Long,

Empirical results

In this section we examine the impact of ownership structure on CEO pay and the pay–performance relationship in Chinese listed firms. We first examine how CEO pay varies across different ownership structure and then explore how are cash flow rights and excess control rights related to CEO pay and pay–performance relationships.

Conclusion

China's ongoing economic reform and corporate restructuring, which focuses primarily on improving management, is accelerating the corporatization of traditional SOEs. CEO and top manager's incentives, being the central theme in such reform and a great concern of the largest shareholders, are poorly understood. We therefore take advantage of the mandate since 2002 that listed firms in China which have to disclose the largest shareholder cash flow rights and control rights in their annual reports

Acknowledgement

The authors are grateful to the valuable comments by an anonymous referee, the suggestions by Jeffry Netter (the Editor), and the comments by Michael Firth. We also thank, for their valuable comments, the participants of the 22nd Australasian Finance and Banking Conference, December, 2009, Sydney, Australia, the 5th International Conference on Asian Financial Markets, December 2009, Nagasaki, Japan, the CHULALONGKORN Accounting and Finance Symposium, November 4–5, 2010, Bangkok, Thailand, and

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