(January 8, 2013) – China’s GDP has grown by 10% a year for the last decade, but in some regions its judicial system is still far from first-world.
For asset owners looking to reduce fraud risk and capitalize in those markets, a new paper suggests looking for two qualities in a firm: political connections and popularity with mutual funds.
“In the past decade, the Chinese government has cultivated institutional investor ownership in Chinese firms to take advantage of an increasingly important external control mechanism for the monitoring of firm management,” finance researchers Wenfeng Wu, Sofia Johan, and Oliver Rui state in the paper. The government’s plan seems to be working: “We find that the firms with a larger proportion of institutional investors, especially mutual fund investors, tend to have lower incidences of fraud.”
For their study “Institutional Investors, Political Connections and Incidence of Corporate Fraud,” the authors ran regression models with a data set of regulatory action against Chinese firms from 2003 to 2011.
The results also confirmed their hypothesis that political connection reduces the frequency of regulatory enforcements against firms. “It indicates that the retaining politically connected CEOs and/or Chairmen can bring certain privileges in the regulatory environment, in that enforcement in the form of fines, public criticism, administrative punishment, warning and even delisting may be eased,” the authors wrote. The weaker the political environment, the more effective political connections were.
Similarly, ownership by institutional investors (of which they include mutual funds) reduced fraud cases in regions with under-developed legal systems—where, for example, property rights aren’t well protect. In stronger judicial environments, however, the results were not statistically significant.
Recent high-profile fraud cases against Chinese companies have highlighted the risks of investing in markets with weak legal protections. In September 2011, institutional shareholders slapped timberland operator Sino-Forest with multi-billion dollar class action lawsuits, alleging that the firm misrepresented financial statements, backdated stock options, and overstated forest holdings in China and elsewhere. Shares in the firm were barred from trading in Ontario, and the company filed for bankruptcy in Canada. In December, an Ontario judge approved a deal to transfer its remaining assets to debt-holders, including several Canadian pension funds.
Read Wenfeng Wu, Sofia Johan, and Oliver Rui’s entire paper here.