Controlling shareholders’ incentives and executive pay-for-performance sensitivity: Evidence from the split share structure reform in China

Int. Fin. Markets, Inst. and Money 34 (2015) 147–160

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Journal of International Financial Markets, Institutions & Money j o u r n a l h o m e p a g e : w w w . e l s e v i e r . c o m / l o c a t e / i n t fi n

Controlling shareholders’ incentives and executive pay-for-performance sensitivity: Evidence from the split share structure reform in China$ Shenglan Chen a,1, Bingxuan Lin b,2 , Rui Lu c, * , Ting Zhang d,3 a

School of Economics and Management, Inner Mongolia University, Hohhot 010021, China College of Business Administration, University of Rhode Island, Kingston,RI 02881, USA Lingnan (University) College, Sun Yat-Sen University, Guangzhou 510275, China d School of Business Administration, University of Dayton, Dayton, OH 45469, USA b c

A R T I C L E I N F O

A B S T R A C T

Article history: Received 19 September 2014 Accepted 25 October 2014 Available online 31 October 2014

Using the split share structure reform in China as a natural experiment, we study how changes in controlling shareholder incentive affect the pay-for-performance sensitivity. The reform converts the shares owned by controlling shareholders from non-tradable to tradable shares. The removal of such market friction allows for a better alignment of interests between controlling and minority shareholders, which gives managers more incentives to improve corporate performance. We find that the pay-for-performance sensitivity improves greatly after the reform. Changes in the pay-for-performance sensitivity are also associated with firm ownership structure, the level of agency conflicts and governance quality. Given that firms with controlling shareholders are the dominant form of business organization in many countries around the world, our results have important implications in that they show that a better alignment between controlling and minority shareholders’ incentives has a significant effect on executive compensation. ã 2014 Elsevier B.V. All rights reserved.

JEL classification: G3 Keywords: Corporate governance Controlling shareholders Pay for performance China market

1. Introduction The relation between executive pay and firm performance is a key factor in determining the effectiveness of CEO compensation structure. Based on the agency framework, researchers generally interpret a higher executive pay-forperformance sensitivity as indicating a better alignment of interests between management and shareholders. However, previous studies have continuously reported mixed results regarding pay-for-performance sensitivity. Studying the U.S. market, Bebchuk and Fried (2004) argue that there is pay without performance, whereas Hall and Liebman (1998) and Conyon and He (2011) report a positive relation between change in performance and change in CEO pay. International evidence is also mixed. Izan et al. (1998) find no evidence of pay for performance among firms in Australia, whereas Colpan and Yoshikawa (2012) find a positive relation between pay and performance in Japan. Florin et al. (2010) survey the executive

$ We are grateful to Katherine Schipper for her valuable comments and suggestions. We thank ananonymous referee for providing comments. We also thank discussants at the 2013 FMA and 2014CICF conferences for their comments. Chen acknowledges the financial support from ChinaNational Natural Science Foundation (No. 71263034) and Program for Changjiang Scholars andInnovative Research Team in University (IRT1258) and Lu acknowledges the financial supportfrom China National Natural Science Foundation (No.70802062, 71272197, 71032006). * Corresponding author. Tel.: +86 208 411 0651. E-mail addresses: [email protected] (S. Chen), [email protected] (B. Lin), [email protected] (R. Lu), [email protected] (T. Zhang). 1 Tel.: +86 471 499 3520. 2 Tel.: +1 401 874 4895. 3 Tel.: +1 937 229 3428.

http://dx.doi.org/10.1016/j.intfin.2014.10.003 1042-4431/ ã 2014 Elsevier B.V. All rights reserved.

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compensation literature and conclude that “it is remarkable that, although hundreds of papers have been written on the subject, there is no real consensus on the relation between executive pay and firm performance”. A major factor that contributes to such complexity but has not been adequately addressed in the literature is the influence that controlling shareholders have over executive compensation contracts. Several comparative corporate governance studies have shown that controlling shareholders represent the prevailing structure in most countries (i.e., Becht and Röell, 1999; La Porta et al., 1999; Faccio and Lang, 2002; Claessens et al., 2000). Even in U.S. firms, controlling shareholders have proven more common than is usually thought (Bebchuk and Weisbach, 2009; Holderness, 2009).1 According to Bebchuk and Weisbach (2009), for firms with controlling shareholders, the conflicts between controlling and minority shareholders often dominate the classic owner-manager connection. Several studies have found controlling shareholders to be associated with a significant amount of tunneling (Bertrand et al., 2002), reduced firm value (Gompers et al., 2009) and lower executive payfor-performance sensitivity (Wang and Xiao, 2011). After providing a comprehensive review of the state of corporate governance research, Bebchuk and Weisbach (2009) called for more studies of controlling shareholders, “given the importance of firms with controlling shareholders in many countries around the world”.2 In this study, we examine the effects of changes in controlling shareholders’ incentives on executive pay-for-performance sensitivity in the context of the split share structure reform in China (hereafter termed the reform). Implemented in 2005 for Chinese listed firms, the reform permits controlling shareholders to convert their formerly non-tradable shares into tradable shares during a specific period (Chen et al., 2012).3 The purpose of the reform is to better align the interests of controlling shareholders with those of minority shareholders. A significant market friction has been removed by the reform, and controlling shareholders are now able to realize gains by selling their shares on the stock market. Controlling shareholders have therefore become more concerned about stock prices and have stronger incentives to monitor managers. Dispersed ownership is also made possible by the reform, making managers more aware of the interests of minority shareholders, which increases their incentives to improve firm performance. A key objective of this study is thus to examine how changes in controlling shareholders’ incentives affect executive pay-for-performance sensitivity. There is another advantage of conducting our research in the context of the reform. Many of the empirical studies on executive compensation must address the issue of endogeneity. Specifically, those controlling shareholders’ incentives and executive compensation might be driven by unknown firm characteristics or business strategies. To mitigate the potential endogeneity issue in executive compensation studies, researchers strive to identify an exogenous event and observe how compensation contracts change. For example, Paligorova (2010) examines the change in pay-for-performance sensitivity following the implementation of the Sarbanes–Oxley Act in 2002. Perry and Zenner (2001) document an increase in pay-forperformance sensitivity after the adoption of Internal Revenue Code Section 162(m). Some studies (e.g., Core and Guay, 2010; Bhagat and Romano, 2010) have examined the usefulness of the Troubled Asset Relief Program and Pay for Performance Act of 2009 by looking at its effect on pay-for-performance sensitivity. The split share structure reform in China represents an exogenous shock that fundamentally changed the incentives of controlling shareholders, thereby providing an interesting setting to examine how the latter affect executive compensation. This study joins the literature on the relation between corporate governance and executive compensation and contributes to it by providing evidence on how controlling shareholders’ incentives affect executive compensation. Furthermore, the reform represents an exogenous shock to a firm’s external governance environment that mitigates the potential endogeneity issue inherent in corporate governance studies. We show that there is a significant increase in executive pay-forperformance sensitivity subsequent to the reform. Such improvement is economically significant and represents an approximately 26.18% increase in pay-for-performance sensitivity relative to the sample average for the pre-reform period. To the best of our knowledge, this study represents the first effort to identify a causal effect of controlling shareholders’ incentives on executive pay-for-performance sensitivity using a security legal reform as a natural experiment. Bebchuk and Weisbach (2009) find that firms with controlling shareholders are the dominant form of business organization in many countries around the world, thus our results have important implications in that they show that a better alignment between controlling and minority shareholders’ incentives significantly affects executive compensation. We also highlight the effects of ownership structure differences and corporate governance quality on the relation between controlling shareholders and executive compensation. Our results show that the improved pay-for-performance sensitivity during the post-reform period is more significant for non-state-owned enterprises (i.e., privately controlled firms) than for state-owned enterprises (SOEs), and for firms with ex-ante larger conflicts between controlling and minority shareholders. Additionally, the pay-for-performance sensitivity experiences greater increases in firms with weaker corporate governance before the reform, suggesting that the reform does result in a pay-for-performance sensitivity improvement. However, corporate governance must be simultaneously strengthened to reach the reform’s full potential.

1 A common type of controlling shareholder in U.S. firms is the so called “controlling minority shareholder” (Bebchuk et al., 2000; Becht and Röell, 1999), who owns a minority of firm cash flow rights but possesses a majority of voting rights. A good example of this is a dual-class stock ownership (Bebchuk and Weisbach, 2009). 2 Bebchuk and Weisbach (2009 further note that “governance arrangements that are optimal for investor protection in companies without a controlling shareholder could be suboptimal for companies with such a controller, and vice versa.” 3 Section 2 details the institutional background of the Chinese stock market and offers a more detailed description of the split share structure reform in China.

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Finally, our study extends previous research on the reform. Lin (2009) concludes that the reform reduced agency conflicts based on evidence of reduced tunneling post-reform. Firth et al. (2010) examine the operational issues (e.g., compensation scheme and risk sharing between controlling and minority shareholders) during the non-tradable shares conversion process. Our study is related to that conducted by Chen et al. (2012), in that both investigate the reform’s effect on a particular economic activity. Chen et al. (2012) focus on firms’ cash holdings decisions, whereas we investigate the post-reform executive pay-for-performance sensitivity. The remainder of this paper is organized as follows. Section 2 discusses the institutional background of the firm ownership structure and regulatory development pertinent to the reform in China. Section 3 reviews the literature and develops the major hypotheses. Section 4 describes the data and sample, and reports the empirical results. We conclude in Section 5. 2. Institutional background 2.1. Ownership structure of China’s listed firms China established its domestic stock exchanges in 1990 to help SOEs with poor performance obtain financial resources and facilitate the transition from a central government-planned economy to a market economy. To maintain control over former SOEs, the government regulates about two-thirds of the total outstanding shares and designates them as nontradable. These shares cannot be bought or sold on the stock exchange, but can be traded through privately negotiated transfers and are usually valued at the book value of a firm’s net assets. During the privatization process, state controlling shareholders sometimes relinquish control to private owners via the privately negotiated transfer of controlling rights. Consequently, controlling shareholders in these companies can be either governments or private investors. The remaining third of outstanding shares are tradable, sold to the public at the market price, and can be bought and sold on the stock exchanges. The split share structure grants tradable and non-tradable shares the same voting and dividend rights,4 and a natural consequence is that controlling shareholders lack incentives to monitor managers' efforts to improve firm performance, because their non-tradable shareholdings do not directly benefit from stock price appreciation. As controlling shareholders cannot freely trade their shares, obtaining private benefits (through tunneling or related party transactions) becomes more important to them than maximizing the value of the stocks. A number of studies (e.g., Groves et al., 1994; Qian, 1996; Chen et al., 2006; Lu et al., 2008; Jiang et al., 2008) have examined the effects of the split share structure on corporate governance and have called for market reform to unfreeze nontradable shares. In general, these studies have suggested that the divergence of interests between controlling and minority shareholders is hazardous to firm performance and governance, and that such a structure fails to effectively monitor and incentivize management. In addition, a large amount of non-tradable shares distorts stock prices. For example, the liquidity premium associated with non-tradable shares can be as high as 80% (Chen and Xiong, 2001). To better address the problems associated with the split share structure, the Chinese government launched a reform of the system in 2005.5 2.2. Split-share structure reform in China The Chinese government issued a series of regulations to undertake reform to allow non-tradable shares to be converted into tradable shares in April 2005.6 The general guidelines issued by the China securities regulatory commission (CSRC) specify four stages: initiation, negotiation, approval, and implementation. Controlling shareholders first initiate the process of converting their non-tradable holdings into tradable shares. Once this is approved by two thirds of non-tradable shareholders, financial intermediaries are consulted to draft the initial proposal. Negotiations are then held between tradable and non-tradable shareholders regarding the conversion ratio for non-tradable shares and the compensation due to tradable shareholders. The proposal is approved if it receives endorsement from more than two thirds of public investors. A critical issue during the reform was the amount of compensation paid to tradable shareholders by non-tradable shareholders and the means of payment (cash or stock) (Li et al., 2011; Firth et al., 2010). The proposal’s implementation could take one or two years, depending on the regulations and the lockup period specified. The pilot program began in April 2005 with four companies, followed by another 42 companies in June 2005, and 35 companies in November 2005. By the end of 2006, about 96% of listed companies had completed the conversion process. Beltratti and Bortolotti (2006) evaluate the market reaction to the 368 firms that conducted the reform and find that, on average, the market responded positively, with an abnormal return of over 8% around the reform announcement three-day window ( 1, +1). They interpret this result as consistent with the expectation of improved corporate governance and stock liquidity following the reform. However, Jiang et al. (2008) examine the post-reform performance of China’s listed

4 Tradable shares are then further classified into different types based on listed exchanges and investors. Specifically, A (B) shares are listed in mainland China for domestic (foreign) investors. H shares are issued by selective “Red Chip” companies traded on the Hong Kong Stock Exchange. N shares are traded on the New York Stock Exchange and S shares are traded on the Singapore Stock Exchange. Non-tradable shares are further classified into five categories based on investor type: state-owned, entrepreneurs, foreign owners, legal entity, and employee shares. 5 In 1999 and 2001, the Chinese government made two failed attempts to sell its state ownership. The attempts were terminated after the market plummeted in response to the news. 6 See Yeung (2009) and Lin (2009) for a detailed review of the reform.

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companies and suggest that the reform by itself is far from sufficient. They argue that simply making all shares tradable or reducing government ownership will not automatically lead to better corporate governance and firm performance. 3. Literature review and hypotheses development The standard principal-agent model (Holmstrom, 1979; Mirrlees, 1997; Murphy, 1999) predicts a positive relation between executive pay and firm performance. A higher pay-for-performance sensitivity indicates better alignment of interests between management and shareholders. Previous studies (e.g., Shivdasani, 1993; Hartzell and Starks, 2003) have found that the presence of large shareholders can strengthen executive pay-for-performance sensitivity because the former have the incentives and resources to monitor managers and mitigate potential entrenchment. However, large shareholders may also expropriate minority shareholders to pursue their own benefits through tunneling or other related-party transactions (Johnson et al., 2000), especially when a country has a weak legal system for protecting minority investors. Tunneling has been found to be more severe in the Chinese stock market. An important reason cited by previous studies (Jiang et al., 2010; Jian and Wong, 2010) is that when controlling shareholders cannot freely trade their stocks through the open market, they can only realize gains from cash distributions, such as tunneling and related-party transactions (Chen et al., 2012). As a result, controlling shareholders are less likely to have improved the pay-for-performance sensitivity before the reform (Wang and Xiao, 2011). We expect the reform to have better aligned the interests of controlling and minority shareholders, as the former's shares have become tradable. Due to the reform, controlling shareholders have stronger incentives to monitor managers and are more likely to reward them for better firm performance. A research report issued by the Shenzhen Stock Exchange (Wu, 2007) also suggests that the reform has provided better incentives for management, thus serving as a more effective mechanism to align the interests of managers and minority shareholders. The reform has also had a direct effect on stock liquidity because the conversion of non-tradable shares into tradable shares significantly increases the stock float. Chordia et al. (2008) suggest that improved liquidity leads to lower trading costs; thus, the stock price incorporates more inside information on managers’ opinions on firm performance. Jayaraman and Milborun (2012) report that an increase in stock liquidity positively affects CEO pay-for-performance sensitivity. Thus, our first hypothesis is as follows: H1. Ceteris paribus, managers’ pay-for-performance sensitivity improves following the implementation of the split share reform in Chinese listed firms. Controlling shareholders typically have power over firms that are significantly in excess of their cash flow rights (La Porta et al., 1999), and their incentives to pursue their own benefits have been found to be stronger when their control rights substantially exceed their cash flow rights. A major reason for this, cited by previous studies (e.g., Lin et al., 2011; Shleifer and Vishny, 1997), is that in this case controlling shareholders have more power to “steal” corporate resources (or to engage in tunneling or other morally hazardous activities), although they bear a smaller proportion of the financial consequences of such activities. As a result, these firms tend to have a lower value (Claessens et al., 2002), lower stock returns (Lemmon and Lins, 2003) and a higher cost of debt (Lin et al., 2011). Masulis et al. (2009) find that managers of firms with a larger degree of separation between ownership and control enjoy more benefits in the form of higher compensation, especially when the CEO is a member of the controlling shareholder group. The reform aims to better align the interests of the controlling and minority shareholders by converting non-tradable shares into tradable stocks. If it has achieved its objective, we would expect firms with a high separation of control rights and cash flow rights pre-reform to experience a more positive change in the pay-for-performance sensitivity. Following previous studies (Claessens et al., 2000; Gompers et al., 2009), we use the separation between cash flow and control rights to measure the degree of agency conflicts between controlling and minority shareholders. Thus, our second hypothesis is stated as follows: H2. Ceteris paribus, the post-reform improvement in pay-for-performance sensitivity is more significant for firms with a higher level of ex-ante agency conflicts. The third hypothesis is related to the effect that ownership identity has on post-reform improvements in executive pay-for-performance. Large shareholders have incentives to use their controlling positions to expropriate wealth from other investors for their own benefit (Shleifer and Vishny, 1997), and such incentives may vary across different shareholder types. In particular, if the large shareholder is a family or an individual, the private benefits of control are concentrated, creating a strong incentive for expropriation. However, if the large shareholder is the State, the incentive to expropriate will be less significant, as the State is an abstract owner of the firm and does not directly benefit from tunneling. Villalonga and Amit (2006) show that if the large shareholder is an institution, it has many independent owners among which the benefits of control are diluted. As a result, this type of large shareholder may have weak incentives to expropriate. This reasoning is supported by several recent studies. For example, Lin et al. (2011) show that the agency costs of controlling shareholders are more severe in non-SOEs than in SOEs. They report that a large degree of the divergence between control and cash flow rights results in firms sustaining a higher cost of debt financing (loan spreads), with an effect that is stronger for family-owned firms than for state-owned firms. Jiang et al. (2010) find that the occurrence of tunneling in controlling shareholders is more severe in non-SOE firms than in SOE firms in China, suggesting a more severe conflict of interests in non-SOE firms. Kato and Long (2006) and Conyon and He (2011) both provide evidence that the pay-for-performance link becomes weaker for SOE managers than for their non-SOE peers. The compensation contracts offered to SOE managers after the reform should exert

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less influence than those offered to non-SOE managers who are now more motivated to maximize firm value. Thus, we propose our third hypothesis7: H3. Ceteris paribus, the post-reform improvement in pay-for-performance sensitivity is more significant for non-SOE firms than for SOE firms. The monitoring role played by large shareholders has been considered a potential mechanism for mitigating the agency problem arising from the separation of ownership and management (Shleifer and Vishny, 1986). Chen et al. (2012) find that firms with weaker pre-reform governance systems significantly lowered their cash holdings after the reform. They interpret this as supporting evidence that the reform motivates controlling shareholders to effectively monitor managers, as their incentives are now better aligned with those of the minority shareholders. Gao and Kling (2008) report that good corporate governance, including outsiders on the board of directors, audit without non-clean opinions, and dispersed ownership prevent tunneling, and asset appropriation. Liu and Lu (2007) show that agency conflicts between controlling and minority shareholders account for a significant portion of Chinese firms’ earnings management through tunneling, but that good corporate governance mitigates this conflict. Shan (2013) reports a negative relation between the number of independent directors and the direct transfer of corporate resources by controlling shareholders for their own benefit. We therefore expect firms with weak pre-reform governance systems to benefit more from the better alignment between controlling and minority shareholders’ incentives. Thus, our fourth hypothesis is stated as follows: H4. Ceteris paribus, the post-reform improvement in pay-for-performance sensitivity is more significant for firms with weaker pre-reform governance. 4. Empirical results 4.1. Data, sample, and descriptive statistics A primary data source for this study is the China Securities Market and Accounting Research (CSMAR) database provided by the GTA information technology company.8 The CSMAR database contains a wide range of data on Chinese publicly listed firms on the Shanghai and Shenzhen stock exchanges, including firm financial statements, stock prices and returns, executive compensation, corporate governance, and the timeline for non-tradable shares reform. We exclude firms in the financial and insurance industries.9 The CSRC has required firms to report information on their three highest-paid executives since 2001. Our sample starts in 2001 to ensure that executive compensation information is disclosed by all of the firms in the sample. We retrieve data on firm ultimate ownership (used to classify firms into SOEs vs. non-SOEs) from the Chinese center for economic research (CCER). In total, we obtain 10 801 firm-year observations from 2001 to 2011. We present the summary statistics for the main variables in Table 1. All of the variables are winsorized at the top and bottom one percentile across years to control for the potential influence of outliers. The average total compensation for the three highest-paid executives increases by RMB438018 (USD69582), from RMB381932 (USD60672) in the pre-reform period to RMB819951 (USD130254) in the post-reform period.10 There is also a significant improvement in firm performance (ROA) between the pre- and post-reform periods (2.2% vs. 3.7%). The sample firms have an average total assets of RMB1.88 billion (USD275.23 million), with a sales growth rate of 24.6% and a leverage ratio of 52%. The stock risk, measured by the standard deviation of monthly stock returns in each year, has an average (median) of 0.131 (0.116). The average (median) Tobin’s Q and capital expenditure for the sample firms are 1.758 (1.376) and 2.633% (1.573%), respectively. Regarding corporate governance characteristics, the sample firms on average have 9.28 directors, 34.2% of whom are independent. Approximately 11.7% of the sample firms have the same person acting as both the CEO and the Chairman, and 56.9% of firms have an executive compensation committee. 4.2. Effect of share reform on executive pay-for-performance sensitivity Our first hypothesis states that executive pay-for-performance sensitivity is stronger after the reform. We construct the following regression model to test this hypothesis:

7 Hou et al. (2013) find that the reform has increased the relation between executive compensation and share return performance among state-controlled listed firms, but not among privately controlled listed firms in China. However, they only examine the data two years after the reform. Changes in executive compensation contracts and their relation to performance often take a longer time to materialize. We find similar results using their sample period and very different results when we expand the period. It takes time for firms to adjust their compensation contracts, and more so for firm performance to reflect such changes in management incentives. Using a longer sample period, we are able to better capture the outcome of the reform. Their empirical models do not specifically control for firm and year fixed effects and their results are likely to be biased. Additionally, their findings are subject to different interpretation because they use the absolute value of compensation instead of the log transformation as the dependent variable in their analyses to minimize the effect of outliers. 8 The CSMAR data (http://www.gtadata.com/index.aspx) can be accessed through the WRDS platform. 9 Industry is defined by the Chinese Public Firms Industry Classification Code. 10 This conversion is based on a CNY/USD exchange rate of 0.1589 at the end of 2011.

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Table 1 Descriptive statistics. All periods(N = 10 801)

Salary ROA Size SalesR Lev Risk Q CTD CEOD BSize IndepR Commit

Pre-reform period(N = 4211)

Post-reform period(N = 6590)

MeanDiff

Mean

Median

SD

Mean

Median

SD

Mean

Median

SD

13.319 0.031 21.471 0.246 0.520 0.131 1.758 2.633 0.117 2.222 0.342 0.569

13.356 0.031 21.366 0.149 0.516 0.116 1.376 1.573 0.000 2.197 0.333 1.000

0.781 0.068 1.153 0.631 0.225 0.058 1.075 3.330 0.321 0.209 0.063 0.495

12.853 0.022 21.112 0.248 0.501 0.099 1.373 2.831 0.107 2.252 0.313 0.156

12.867 0.028 21.041 0.160 0.491 0.093 1.233 1.696 0.000 2.197 0.333 0.000

0.678 0.067 0.949 0.602 0.230 0.038 0.524 3.511 0.309 0.216 0.072 0.363

13.617 0.037 21.700 0.245 0.531 0.151 2.004 2.506 0.123 2.202 0.361 0.834

13.638 0.033 21.613 0.144 0.535 0.140 1.584 1.517 0.000 2.197 0.333 1.000

0.691 0.068 1.213 0.649 0.220 0.060 1.250 3.202 0.328 0.203 0.049 0.372

0.764a 0.015a 0.587a 0.002a 0.030b 0.051b 0.631b -0.323b 0.016a -0.050a 0.048b 0.678a

This table presents the summary statistics for the major variables. All of the variables are winsorized at the top and bottom percentile across years to control for the potential influence of outliers. The data are obtained from the China Securities Market and Accounting Research (CSMAR) database provided by the GTA Information Technology Company. We exclude firms in the financial and insurance industries, and industry is defined by the Chinese Public Firms Industry Classification Code. The sample period is from 2001 to 2011, which includes 10 801 firm-year observations. The variables are defined in Appendix A. a Significant at the 5% level. b Significant at the 1% level.

Log(Salary) = a + b1ROA + b2Post + b3Post  ROA + b4Size + b5SalesR + b6Lev + b7Risk + b8Q + b9CTD + b10CEOD + b11BSize + b12IndepR + b13Commit + e (1) For brevity, we describe the construction of the major variables below, including Log(Salary), Post, ROA and the interaction variable Post  ROA. We summarize all of the variable definitions in Appendix A. Log(Salary): the logarithm of the aggregate compensation (base salary and bonus) for a firm’s three highest-paid executives. Post: a dummy variable that equals one if a firm completes its share reform in year t and afterwards, and 0 otherwise.11 ROA: A measure of firm performance, estimated as net income divided by average total assets of beginning and ending year.12 Post  ROA: an interaction term between the firm performance measure and the reform dummy. We focus on cash compensation because shares and stock options were rarely used for Chinese listed firms in our sample period. Although some firms also used other forms of incentive compensation, such as stock options and restricted stock, these firms account for less than 5% of the total listed firms (Cao et al., 2011). The use of cash compensation is also consistent with previous research (Firth et al., 2006, 2007; Cao et al., 2011; Conyon and He, 2011; Wang and Xiao, 2011). The variable of interest in the regression equation is the interaction term Post  ROA. If the reform improves executive pay-for-performance sensitivity (H1), we expect a positive and significant coefficient for Post  ROA. Since different firms complete reform in different years, we apply a general difference-in-differences model to handle multiple time periods and multiple treatment groups proposed by Bertrand et al. (2004). The regression model is: Log(Salary) = at + ai + u1ROAi,t + u2Posti,t + u3Posti,t  ROAi,t + bXi,t + ei,t

(2)

where at and ai are year and firm fixed effects, Xi,t are control variables, Posti,t is a dummy variable that equals one if the firm i completes its reform in year t. This methodology controls for fixed differences between treated and non-treated firms via the firm fixed effects. The year dummies control for aggregate fluctuations. Chen et al. (2012) use this difference-in-differences model to examine the effect of the reform on corporate cash holdings, while we focus on the effect of the reform on pay-forperformance sensitivity. Table 2 reports the regression results for Eq. (1) using both the ordinary least squares (OLS) (after controlling for industry and year effects) and Eq. (2) using difference-in-differences methods to identify the reform’s effects apart from time-specific changes. The t-statistics reported in parentheses are estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). The sample period is from 2001 to 2011, which includes 10 801 firm-year observations. As predicted, Post  ROA has a positive and significant coefficient using both the OLS and difference-in-differences methods. For example, the coefficient shown in column (1) using the OLS regression is 0.557, significant at the 1% significance level (t = 2.61). When the difference-in-differences method is used in column (2), the coefficient for Post  ROA remains positive and significant (b = 0.449, t = 2.61). Consistent with our first hypothesis (H1), these results indicate that executive

11 For example, if a firm finished the reform in July 2007, the dummy variable Post takes the value of one for the years 2007–2011, and 0 for the years 2001– 2006 in our sample. Our major results do not change significantly if we assign the value of one for the years 2008–2011 and 0 for 2001–2007. 12 Conyon and He (2012) suggest that in China, accounting rather than stock performance is the most important variable driving CEO pay.

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Table 2 Regression analysis of the effect of the shares reform on executive pay-for-performance sensitivity. Dependent variable: Log(Salary) OLS regression

ROA Post ROA  Post Size SalesR Lev Risk Q CTD CEOD BSize IndepR Commit Intercept Firm fixed effect Industry fixed effect Year N adj. R-sq N_clust F

Difference-in-difference regression

Coefficient

t-value

Coefficient

t-value

2.127c 0.004 0.557c 0.263c 0.047c 0.002 0.414c 0.059c 0.004a 0.075b 0.298c 0.456c 0.091c 6.037c

(11.84) (0.14) (2.61) (22.88) ( 5.98) ( 0.04) ( 2.98) (5.71) (1.92) (2.58) (5.98) (2.87) (3.81) (23.41)

1.077c 0.407c 0.449c 0.294c 0.029c 0.025 0.527c 0.056c 0.003b 0.065c 0.221c 1.108c 0.155c 5.791c

(7.33) (15.83) (2.61) (19.91) ( 4.06) ( 0.52) ( 5.98) (8.08) (2.18) (3.01) (4.67) (8.66) (9.50) (17.44) Yes

Yes Yes 10 801 0.578 1265 192.326

Yes 10 801 0.618 1265 290.735

This table reports the regression results for Eq. (1) using the OLS (after controlling for industry and year effects) and Eq. (2) using difference-in-differences method to identify the effect of the reform separately from time-specific changes. All of the models are estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). The robust t-statistics are reported in parentheses. The sample period is from 2001 to 2011, which includes 10 801 firm-year observations. The variables are defined in Appendix A. a Significant at the 10% level. b Significant at the 5% level. c Significant at the 1% level.

pay-for-performance sensitivity has increased since the reform. The magnitude of this effect is economically significant; that is, the coefficient of 0.557 (column (1)) represents a 26.18% (=0.557/2.127) improvement from the sample pre-reform pay-for-performance sensitivity average of 2.127. Equivalently, our results suggest that after the reform, a one standard deviation improvement (or 6.8%) of ROA is associated with an RMB31076 (or USD4937) increase in executive cash compensation. The results for the control variables are also consistent with those of previous studies. Specifically, firm size positively affects executive compensation (i.e., Murphy, 1999), and leverage ratio and stock volatility negatively affect compensation (Conyon and He, 2011; Wang and Xiao, 2011). There is a positive relation between executive compensation and Tobin’s Q (a proxy for firm growth opportunity), CEO/chairman duality, board size, capital expenditure, and the existence of an executive compensation committee, as reported by Chen et al. (2010). The sales growth rate is negatively related to executive compensations, and similar evidence is reported by Cao and Wang (2013). The literature contains mixed evidence of the effects of independent directors on executive compensation and firm value (e.g., Clarke, 2006; Weisbach, 1988; Rosenstein and Wyatt, 1990). We find a positive relation between the percentage of independent directors and executive compensation. 4.3. Effect of firm agency conflicts If the reform has increased executive pay-for-performance sensitivity, we would expect the effect to be stronger for firms with more severe pre-reform agency conflicts (H2). We create a dummy variable CV to indicate firms with more severe agency conflicts issues. CV takes the value of one if a firm’s ultimate owner has separated cash flow and controlling rights, and 0 otherwise. This information on whether a firm’s ultimate owner has separated cash flow and controlling rights is obtained from the CSMAR database. The regression model is constructed as follows: Log(Salary) = a + b1ROA + b2Post + b3Post  ROA + b4CV+ b5Post  CV + b6ROA  CV + b7Post  ROA  CV + b8CashR + b9BSize + b10SalesR + b11Lev + b12Risk + b13Q + b14CTD + b15CEOD + b16BSize + b17IndepR + b18Commit + e

(3)

The variable of interest in Eq. (2) is the interaction term Post  ROA  CV. Based on H2, we expect a positive coefficient for Post  ROA  CV. Consistent with our expectation, Table 3 shows that the coefficient for POST  ROA  CV is positive and significant (b = 1.191, t = 2.46). This result implies that the share reform has had a stronger effect on executive pay-forperformance sensitivity for firms with separated cash flow and controlling rights—an indication of agency conflict between controlling and minority shareholders. In addition, the control variables produce similar results to those reported in Table 2.

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Table 3 Regression analysis of the effect of rights separation on executive pay-for-performance sensitivity. Dependent variable: Log(Salary)

ROA Post Post  ROA CV Post  CV ROA  CV Post  ROA  CV CashR Size SalesR Lev Risk Q CTD CEOD BSize IndepR Commit Intercept Industry fixed effect Year N adj. R-sq N_clust F

Coefficient

t-value

2.433c 0.008 0.607b 0.011 0.049 1.661c 1.191b 0.328c 0.269c 0.054c 0.070 0.430c 0.053c 0.004a 0.074b 0.314c 0.302 0.107c 6.620c

(9.25) (0.22) (1.98) ( 0.32) ( 1.54) ( 4.06) (2.46) ( 4.57) (22.81) ( 6.08) ( 1.48) ( 3.03) (5.25) (1.76) (2.45) (5.79) (1.62) (4.52) (24.62) Yes Yes 8528 0.540 1240 127.194

This table reports the regression results for Eq. (3) using OLS (after controlling for industry and year effect) methods. All of the models are estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). The robust t-statistics are reported in parentheses. The variables are defined in Appendix A. a Significant at the 10% level. b Significant at the 5% level. c Significant at the 1% level.

4.4. Effect of different ownership structure The following regression model is used to test the effect of firm ultimate ownership on executive pay-for-performance sensitivity (H3): Log(Salary) = a + b1ROA + b2Post + b3Post  ROA + b4SOE + b5Post  SOE + b6ROA  SOE + b7Post  ROA  SOE + b8BSize + b9SalesR + b10Lev + b11Risk + b12Q + b13CTD + b14CEOD + b15BSize + b16IndepR + b17Commit + e (4) SOE is a dummy variable indicating a firm’s ultimate ownership in Eq. (4). It takes the value of 1if a firm is ultimately controlled by the state government, and 0 otherwise. The variable of interest in the regression equation is the interaction term Post  ROA  SOE. If the post-reform effect is weaker for SOEs than for non-SOEs (H3), we expect a negative and significant coefficient for Post  ROA  SOE. Columns (1) and (2) in Table 4 report the regression results for Eq. (4) using the OLS method after controlling for industry and year effects. The variable of interest, POST  ROA  SOE, has a negative and significant coefficient in column (1) (b = 1.285, t = 2.94). Consistent with H3, this result indicates that the positive effect that share reform has on executive pay-for-performance sensitivity is weaker for SOEs than for non-SOEs. 4.5. Effect of corporate governance quality Our fourth hypothesis states that the improvement in pay-for-performance sensitivity following the implementation of the reform is more significant for firms with more pre-reform governance issues, as they benefit most from the reform. Following Chen et al. (2012), we create two dummy variables to indicate firms with more corporate governance issues: AbRPT and ExCash. AbRPT is a dummy variable that equals one for firms experiencing a large post-reform reduction in abnormal related-party transactions between the listed and the parent company (or its affiliates)—an indication of a weak pre-reform corporate governance system. We first estimate the firms’ total amount of abnormal related-party transactions based on Jian and Wong (2010), and then calculate the difference in pre- and post-reform abnormal related-party transactions. We sort all of the firms into three groups in each year based on the differences, and assign those firms in the bottom (top) group as AbRPT = 1(AbRPT = 0).

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155

Table 4 Regression analysis of the effect of firm ownership on executive pay-for-performance sensitivity. Dependent variable: Log(Salary)

ROA Post Post  ROA SOE Post  SOE ROA  SOE Post  ROA  SOE Size SalesR Lev Risk Q CTD CEOD BSize IndepR Commit Intercept Industry fixed effect Year N adj. R-sq N_clust F

Coefficient

t-value

0.863c 0.059 1.365c 0.088c 0.097c 2.025c 1.285c 0.263c 0.042c 0.022 0.311b 0.056c 0.004a 0.081c 0.301c 0.446c 0.097c 6.095c

(3.46) ( 1.63) (4.34) ( 2.90) (3.14) (6.04) ( 2.94) (22.18) ( 5.27) ( 0.48) ( 2.22) (5.53) (1.84) (2.79) (6.03) (2.81) (4.08) (23.29) Yes Yes 10 801 0.579 1265 173.138

This table reports the regression results for Eq. (4) using OLS (after controlling for industry and year effect) method. All of the models are estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). Robust t-statistics are reported in parentheses. The variables are defined in Appendix A. a Significant at the 10% level. b Significant at the 5% level. c Significant at the 1% level.

ExCash is a dummy variable that equals one for firms experiencing a large post-reform reduction in excess cash holdings (Chen et al., 2012)—an alternative measure of weak pre-reform corporate governance. We first estimate firm excess cash holdings based on previous studies that examine the determinants of firm cash holdings (Opler et al., 1999; Dittmar and Mahrt-Smith, 2007; Gao et al., 2013), and then calculate the difference inpre- and post-reform excess cash holdings. We sort all of the firms into three groups in each year based on the differences, and assign those firms in the bottom (top) group as ExCash = 1(ExCash = 0). We use the following two equations to test our hypothesis: Log(Salary) = a + b1ROA + b2Post + b3Post  ROA + b4AbRPT + b5Post  AbRPT + b6ROA  AbRPT + b7Post  ROA  AbRPT + b8BSize + b9SalesR + b10Lev + b11Risk + b12Q + b13CTD + b14CEOD + b15BSize + b16IndepR + b17Commit + e (5a) Log(Salary) = a + b1ROA + b2Post + b3Post  ROA + b4ExCash + b5Post  ExCash + b6ROA  ExCash + b7Post  ROA  ExCash + b8BSize + b9SalesR + b10Lev + b11Risk + b12Q + b13CTD + b14CEOD + b15BSize + b16IndepR + b17Commit + e (5b) Our variables of interest are the interaction terms Post  ROA  AbRPT in Eq. (5a) and Post  ROA  ExCash in Eq. (5b), respectively. We expect the coefficients for both variables to be positive. Table 5 presents the regression results for Eqs. (5a) and (5b). As expected, the coefficient for the interaction term Post  ROA  AbRPT is positive and significant (b = 1.456, t = 2.21) in column (1). The sample average pre-reform sensitivity is 1.805 (2.329) for firms experiencing a small (large) postreform reduction in abnormal related-party transactions. The coefficients indicate that the share reform has increased the pay-for-performance sensitivity by 71.19% [=(0.202 + 1.456)/2.329)] (11.19% [=0.202/1.805]) for firms experiencing a large (small) reduction in abnormal related-party transactions. The interaction term Post  ROA  ExCash also has a positive and significant coefficient (b = 1.527, t = 2.13) in column (2). The sample average pre-reform pay-for-performance sensitivity is 1.498 (0.848) for firms with a small (large) post-reform reduction in cash holdings. Again, the coefficient of 1.527 implies that the share reform has increased the sensitivity by 25.90% (=0.388/1.498) for firms experiencing a small reduction in cash holdings and increased it by 225.83% [(0.388 + 1.527)/ 0.848) for firms with a large reduction in cash holdings. In addition to using dummy variables, we use continuous variables to measure the changes in abnormal related-party transactions (DAbRPT) and the changes in post-reform excess cash holdings (DExCash). A small negative DAbRPT or DExCash indicates that firms have improved corporate governance post-reform, relative to pre-reform. We then interact DAbRPT and DExCash with Post  ROA. Consistently, we obtain a negative coefficient for Post  ROA  DAbRPT (b = 0.576,

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Table 5 Regression analysis of the effect of firm abnormal related-party transactions and excess cash holdings on executive pay-for-performance sensitivity. Dependent variable: Log(Salary)

ROA Post Post  ROA AbRpt Post  AbRpt ROA  AbRpt Post  ROA  AbRpt ExCash Post  ExCash ROA  ExCash Post  ROA  ExCash Size SalesR Lev Risk Q CTD CEOD BSize IndepR Commit Intercept Industry fixed effect Year N adj. R-sq N_clust F

Coefficient

t-value

Coefficient

t-value

1.805c 0.001 0.202 0.088b 0.085b 0.524 1.456b

(6.46) (0.02) (0.60) (2.34) ( 2.17) (1.08) (2.21)

1.498c 0.050 0.388

(4.20) ( 0.88) (0.95)

0.018 0.054 0.650 1.527b 0.209c 0.039c 0.006 -0.110 0.025a 0.004 0.006 0.234c 0.001 0.044 7.698c

(0.46) ( 1.41) ( 1.17) (2.13) (11.64) ( 3.40) (0.09) (-0.55) (1.70) (1.26) (0.15) (3.23) (0.00) (1.26) (19.47) Yes Yes 6517 0.394 786 60.301

0.261c -0.058c -0.052 -0.502c 0.059c 0.004 0.032 0.324c 0.259 0.012 6.084c

(16.95) ( 5.72) ( 0.86) ( 2.73) (4.58) (1.37) (0.82) (4.99) (1.23) (0.39) (17.64) Yes Yes 6545 0.568 852 106.622

This table reports the regression results for Eqs. (5a) and (5b) using the OLS (after controlling for industry and year effect) method. All of the models are estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). The robust t-statistics are reported in parentheses. The variables are defined in Appendix A. a Significant at the 10% level. b Significant at the 5% level. c Significant at the 1% level.

t = 2.85) and Post  ROA  DExCash (b = 2.784, t = 2.08).13 Overall, these results are consistent with H4 and show that the post-reform improvement in pay-for-performance sensitivity is more significant for firms with more pre-reform governance issues. 4.6. Additional test of the reform’s effect on firm performance and investment decisions Motivated by Chen et al. (2012), who report that the share reform has had a positive effect on firm performance and capital expenditure, our final exercise is to examine the effects of the reform on firms’ performance and capital expenditure using the following regression model: ROA = a + b1Post + b2Size + b3SalesR + b4Lev + b5Risk + b6Q + b7CTD + b8CEOD + b9BSize + b10IndepR + b11Commit + e (6a) CAPEX = a + b1Post + b2Size + b3SalesR + b4Lev + b5Risk + b6Q+ b7CTD + b8CEOD + b9BSize + b10IndepR + b11Commit + e (6b) Table 6 presents the regression results. In column (1), with ROA as the dependent variable, the coefficient estimate for Post is positive and significant (b = 0.021, t = 10.76), suggesting that firms experience significant post-reform performance improvement. Given the sample average pre-reform ROA of 0.022, this coefficient for Post implies a nearly 91.6% (=0.022/ 0.024) post-reform improvement. Column (2) uses CAPEX as the dependent variable. The coefficient for Post is positive and significant (b = 0.008, t = 2.27). This result indicates that, on average, firms increase their CAPEX by about 15.69% (=0.008/ 0.051 where 0.051 is the sample average for the pre-reform CAPEX). Overall, our results are consistent with those of Chen et al. (2012) and suggest that the share reform has positively affected firm performance and capital expenditure.

13

These results are available from the authors upon request.

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157

Table 6 Regression analysis of the effect of the reform on investment, performance. Explanatory variable: ROA Column (1) Coefficient Post Size SalesR Lev Risk Q CTD CEOD BSize IndepR Commit Intercept Industry fixed effect Year N adj. R-sq N_clust F

0.021c 0.014c 0.020c 0.101c 0.083c 0.013c 0.001c 0.000 0.000 0.001 0.005c 0.238c

t-value (10.76) (23.70) (27.44) ( 32.07) ( 9.44) (15.07) (12.30) (0.29) (0.20) (0.09) (4.53) ( 17.83) Yes Yes 10 801 0.427 1271 80.520

Explanatory variable: CAPEX Column (2) Coefficient 0.008b 0.010c 0.014c 0.013c 0.067c 0.000 0.021c 0.002 0.013c 0.024a 0.001 0.247c

t-value (2.27) (11.96) (11.39) ( 3.89) ( 5.06) (0.20) (55.82) ( 0.75) (3.58) (1.88) (0.56) ( 13.00) Yes Yes 10 597 0.581 1273 144.231

This table reports the regression results for Eqs. (6a) and (6b) using the OLS (after controlling for industry and year effect) method. All of the models are estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). The robust t-statistics are reported in parentheses.The variables are defined in Appendix A. a Significant at the 10% level. b Significant at the 5% level. c Significant at the 1% level.

4.7. Robustness tests 4.7.1. Endogenous timing choice To investigate the reform’s effect on executive pay-for-performance sensitivity, we use both the OLS and difference-indifference regression methods. A key assumption of the difference-in-difference regression is that the reform represents an exogenous event to executive compensation. We believe this is a valid assumption, as the reform is mandatory and firms Table 7 2SLS regression analysis of the effect of the share reform on executive pay-for-performance sensitivity after controlling for firm strategic timing choice. Dependent variable: Log(Salary)

Post ROA  Post ROA Size SalesR Lev Risk Q CTD CEOD BSize IndepR Commit Intercept Industry fixed effect Year N N_clust F

Coefficient

t-value

8.675c 36.947c 18.343b 0.217c 0.018 0.755c 0.276 0.198b 0.027c 0.107a 0.415c 1.906c 0.112b 7.902c

( 2.58) (2.99) ( 2.54) (6.63) ( 0.42) ( 3.01) ( 0.73) ( 2.31) (3.33) (1.91) (4.32) (3.48) (2.38) (8.75) Yes Yes 7237 1224 27.623

To control for the endogenous timing issue, we use two instrumental variables: dummy2/3 and %non-tradable. Dummy2/3 is an indicator variable that equals one if the controlling shareholder owns more than two thirds of all non-tradable shares. %Non-tradable refers to the percentage of shares that are non-tradable. This table reports the second stage results of the 2SLS regression. The regression is estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). The robust t-statistics are reported in parentheses.The sample period is from 2003 to 2009, which includes 7273 firmyear observations. The variables are defined in Appendix A. a Significant at the 10% level. b Significant at the 5% level. c Significant at the 1% level.

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generally have no discretion in timing it. Nonetheless, as Chen et al. (2012) note, we cannot completely exclude the possibility that firms strategically time the reform after considering their corporate policies. To control for the endogenous timing issue, we follow Chen et al. (2012) and adopt an instrumental variables (IV) method. Two instrumental variables are used. The first is dummy2/3 and the second is %non-tradable. Dummy2/3 is an indicator variable that equals one if the controlling shareholder owns more than two-thirds of all non-tradable shares, because the reform would not start until two-thirds of the non-tradable shareholders agree on a compensation plan for the tradable shareholders. %Non-tradable is the percentage of shares that are non-tradable. This measure is used as an IV because the higher the percentage of non-tradable shares, the larger the benefit to shareholders when these non-tradable shares are converted to tradable shares. Table 7 reports the two-stage least squares (2SLS) regression results. We report the second-stage results only to save space. The results are estimated with robust standard errors clustered by firm, as recommended by Petersen (2009). The robust t-statistics are reported in parentheses. We observe that the variable of interest, ROA  Post, maintains a positive and significant coefficient. This suggests that including the timing factors does not alter our main results and inferences. 4.7.2. Using change regressions and a fixed-effect model It is possible that our regression specifications fail to account for time-invariant unobservable variables that might simultaneously affect executive compensation, firm performance and choice of reform. We use two methods to alleviate this concern. First, following Lin et al. (2011), we use a change regression to examine the effects of changes in ROA on changes in executive compensation. To be specific, the dependent variable DLog(Salary) in year t is measured as the difference between Log(Salary) in year t and t 1. Similarly, all of the independent variables previously shown in Eq. (1) are measured as the year-over-year change. Second, we augment the OLS regression reported in Table 2 with firm fixed effects. For both methods, we find that the major results reported in Table 2 hold, although they become somewhat weaker. The regression results for both the change regression and fixed effects model are not tabulated in this section to conserve space. 5. Conclusions Pay-for-performance sensitivity is an important measure for evaluating the effectiveness of compensation contracts and how well managers align their interests with those of shareholders. Using the event of the non-tradable share reform in China as an exogenous shock, we examine how pay-for-performance changes following the implementation of the reform. We find that better incentive alignment between controlling and minority shareholders is associated with improved pay-forperformance sensitivity in our sample firms. Furthermore, we find that the improvement in pay-for-performance sensitivity increases mainly for non-SOE firms and those that have a low governance quality and greater agency conflicts before the reform. This study provides additional evidence of the effect of the non-tradable share reform, focusing on the incentives of controlling shareholders. The removal of market friction and the improved stock liquidity has led to better incentive alignment between controlling and minority shareholders. However, for the share reform to take full effect, simultaneous improvements in corporate governance are also needed. The presence of controlling shareholders is a common feature of corporate governance in emerging markets. However, there have been very few studies on the interactions between controlling shareholders’ incentives and the governance mechanism aligning the interests of management and shareholders in emerging markets. Our findings reveal that controlling shareholders’ incentives significantly affect management compensation contracts. A better alignment of interests between controlling and minority shareholders could lead to better pay-for-performance sensitivity and greater efficiency of management compensation contracts. It would be fruitful to expand this study and examine how controlling shareholders’ incentives lead to other changes in corporate governance, such as CEO turnover or changes in board structure. Appendix A. Variable definitions. Variable

Definition

Salary ROA Post Size SalesR Lev Risk Q

The logarithm of the aggregate current compensation (base salary and bonus) for a firm’s three highest-paid executives. Firm performance measure, estimated as firm net income divided by the average total assets. A dummy variable that equals one if a firm completes its non-tradable shares reform in year t, and 0 otherwise. The logarithm of firm total assets. The year-over-year sales growth rate. Leverage ratio, estimated by dividing the long-term debt (including the current portion of long-term debt) by total assets. The standard deviation of monthly stock returns in each year. Tobin’s Q, estimated as the market capitalization of the stock (tradable shares multiplied by the stock price at the fiscal year end), plus nontradable shareholders’ equity, plus total debt, divided by total assets. Firm capital expenditure and depreciation expenses divided by total sales. A dummy variable that equals one if a firm has the same person acting as both CEO and chairman of the board of directors, and 0 otherwise. Board size, estimated as the logarithm of the number of directors on the board. The percentage of independent directors. A dummy variable that equals one if a firm has an Executive Compensation Committee on the board, and 0 otherwise. A dummy variable indicating a firm’s ultimate ownership, which equals one if a firm is a state-owned enterprise, and 0 otherwise.

CTD CEOD BSize IndepR Commit SOE

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159

(Continued) Variable

Definition

CV CashR

A dummy variable equals one if a firm’s ultimate owner has separated cash flow and controlling rights, and 0 otherwise. The cash flow rights of the largest ultimate owner of the firm, estimated as the product of the proportion of voting rights at different levels of the control chain. AbRPT is a dummy variable equal to one for firms experiencing a large reduction in abnormal related-party transaction between the listed and the parent company (or its affiliates) after the reform (Chen et al., 2012). We first estimate firm total amount of abnormal related-party transactions based on Jian and Wong (2010), and then calculate the difference in abnormal related-party transactions between the pre- and post-reform periods. We sort all of the firms into three groups in each year based on the differences, and assign those firms in the bottom (top) group as AbRPT = 1(AbRPT = 0). ExCash is a dummy variable that equals one for firms experiencing large reduction in cash holdings after the reform (Chen et al., 2012). We first estimate firm excess cash holdings based on previous studies that examine the determinants of firm cash holdings, and then calculate the difference in excess cash holdings between the pre- and post-reform. We sort all of the firms into three groups in each year based on the differences, and assign those firms in the bottom (top) group as ExCash = 1(ExCash = 0). Firm capital expenditure, measured as the ratio of total amount of capital expenditure over non-cash assets.

AbRPT

ExCash

CAPEX

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