Appointment of Political Top Executives and Subsequent Performance and Corporate Governance: Evidence from China s Listed SOEs

Transcription

1 Appointment of Political Top Executives and Subsequent Performance and Corporate Governance: Evidence from China s Listed SOEs Fang Hu Department of Accountancy, Faculty of Business, City University of Hong Kong. achufang@cityu.edu.hk Sidney C. M. Leung Department of Accountancy, Faculty of Business, City University of Hong Kong. acsleung@cityu.edu.hk December 2008 Thanks to all seminar participants in City University of Hong Kong. 1 Electronic copy available at:

2 Abstract This paper investigates the replacement and appointment of top executives in a business highly involved by the government and their consequences on firm performance and corporate governance. It provides a dynamic setting to test the value of political connection as prior studies do not discern government interests and incorporate ambiguous institutions and self-selection problems by cross-section test. Using data of China s listed state-owned enterprises (SOEs), this paper finds that the state owner is more likely to replace top executives and appoint a politically-connected executive when SOEs encounter economic distress such as poor ROA, earnings loss, high financial risk, or political distress such as SEC regulation violation. It implies that the politically-connected executive may be considered helpful by the government in response to firm distress. Further, it is found that the political top executives improve firm performance following their appointments and reduce the frequency of executives illegal actions, by initiating modification of internal governance structures and mitigating manager s discretion. And those firms do not have preferential access to resources or government assistances such as fiscal subsidies, tax benefits, or the credit market. All these findings support that political executives could serve as a disciplinary or monitoring mechanism in a political economy lack of external market for corporate control and legal protection for investors, instead of being only a form of bail-out. Their efficacy is based on their administrative power, regulatory expertise and accountability to the government interests. These results provide better understanding of government interests and their impact on corporate governance. Key Words: Appointment of top executives, Politically-connected executives, Firm performance, Corporate governance. 2 Electronic copy available at:

3 1. Introduction Motivated by the growing debate on the role of political institutions (e.g., Shleifer and Vishny, 1994; Shleifer, 1998; Qian, 1995, 1996; Fisman, 2001; Fan, Wong, and Zhang, 2006; Faccio, 2006), this paper studies management appointment and corporate governance in a political economy by exploring the replacement and appointment of top executives and their consequences in China s listed state-owned enterprises (SOEs). 1 Anecdotal evidence indicates that in some Chinese SOEs, the government appoints a politician to replace the chairman of the board or chief executive officer (CEO) in its affiliated enterprises when these enterprises encounter troubles in financial performance. For example, in 2004, the local government appointed Zhao Yong, who was the vice mayor of Mianyang in Sichuan Province, to the position of Chairman of the Board in a local backbone state enterprise, Sichuan Changhong Electric Co. (SEC code: ), which had suffered huge losses following fraud and legal disputes with APEX Co. in the United States (see more examples in Appendix C). 2 The issue is the action of a state owner in appointing top executives with political backgrounds. What does the government consider when appointing political figures as top managers of SOEs? What effects do certain managerial appointments have on firm performance? And, what roles do these political executives play in firm performance and corporate governance? The answers to these questions are important for understanding government involvement in corporate governance and the influence 1 The debates on political institutions focus on the role of politically connected owners/senior managers/directors in the firm. In the paper, I use the term political executive for simplicity. 2 Referred to as news on the Internet. All news is in Chinese. 3 Electronic copy available at:

4 of government interests on enterprises. In this study, we first examine whether the likelihood of the appointment of a political top executive is associated with preceding firm performance, to attempt to clarify the role of political top executives in state owner (government) interests. The turnover-performance relationship has been well established in the prior literature, and it has generally been concluded for diffused-owned firms that i) in response to poor performance, shareholders are likely to remove incumbent executives and appoint new executives who are perceived to be helpful in improving performance for firm survival (Guest, 1962; Helmich and Brown, 1972; Pfeffer, 1981; Dalton and Kesner, 1983; Schwartz and Menon, 1985); ii) in response to good performance, newly appointed executives are perceived to maintain the firm s strategy or act out of self-interest (Morck, Shleifer, and Vishny, 1988; Puffer and Weintrop, 1991); or iii) the appointment of executives could have nothing to do with antecedent firm performance. Overall, the relationship between the appointment of executives and preceding firm performance reflects the perception of shareholders of the role of certain executives in corporate governance. Those studies that document the appointment of managers by shareholders in the competitive US market provide a framework to examine the appointment of political executives to top management positions in SOEs by the government, as the major shareholder, who also has the incentive problems of shareholders and managers despite the objectives of politicians. In particular, the prior literature suggests three hypotheses for the appointment of political executives on the board: to extract rents from firms (the grabbing hand model) 4

5 (Shleifer and Vishny, 1994, 1998; Chang and Wong, 2002; Fan, Wong, and Zhang, 2006), to control agency problems politically (the helping hand model) (Shleifer and Vishny, 1998; Qian, 2000; Li, 2000; Chang and Wong, 2004), or having no influence and serving as window dressing. Hence, examining appointment of political executives responsive to firm performance is a direct way to discern government interests in SOEs. We use 696 listed SOEs in China from 2001 to 2005 as the sample. The empirical results show that a state owner is more likely to replace the incumbent chairman or CEO and to appoint a political executive when the SOE displays poor performance or distress, which suggests that political executives are perceived to play a helpful role. In the sample in which the chairman of the board or CEO is replaced during the period, more than one half of the new top executives have political backgrounds. The results of logistic regression show that the appointment of political executives is significantly positively associated with poor performance (economic distress) such as poor accounting performance (ROA), earnings loss (net income less than zero), or a high degree of financial risk, or political distress, such as SEC regulation violation. In contrast, the appointment of non-politically connected managers is not significantly associated with preceding firm performance. The second part of this study evaluates firm performance and corporate governance structure subsequent to the appointment of political top executives, to further distinguish the roles of political top executives in the governance of SOEs. Although political executives are likely to be appointed following poor firm 5

6 performance and are perceived to be helpful, two views exist as to their role implemented ex post in distressed SOEs. Some scholars argue that newly appointed political executives play a monitoring or disciplinary role in corporate governance. That is, they are more qualified to initiate a big change in corporate strategy and/or internal governance structure, substituting for external market pressure for corporate control (Qian, 1995, 1996; Li, 2000; Chang and Wong, 2004). Others believe, however, that new political executives are appointed only as a form of bailout by the government, and do not reduce agency costs or monitor managers or employees (Krueger, 1990; Qian and Gerard, 1996; Shirley and Walsh, 2000; Krueger, 1990; Faccio, 2006). Both of these views are based largely on anecdotal or indirect evidence. By empirically testing the consequences of the appointment of political top executives (event years 2 years before through 3 years after the appointment), the findings show that the accounting firm performance (ROA) of SOEs significantly increases and there is a lower frequency of earnings losses and lower frequency of regulation violations following the appointment of political executives. Such improvements in performance are not observed for firms that have replacement and appointment of non-political executives, that is, those top executives who have no political backgrounds. In particular, in the three years following the appointment of political executives, the frequency of regulation violations is significantly lower, around 5% less, than after the appointment of non-political executives. Moreover, the results show a higher employee turnover rate, significantly more independent 6

7 directors on the board, and a lower frequency of dual chairman and CEO position following the appointment of political executives. In particular, in the year +2 following the appointment of political executives, the frequency of this dual position is significantly lower, around 5% less, than after the appointment of non-political executives. Although not all of these differences are significant, the findings indicate that political executives do indeed improve firm status and initiate changes and improvement in the governance structure of firms. The findings of this study contribute to the literature in three ways. First, they extend the prior research on the role of political connections in the corporate governance (Fan, Wong, and Zhang, 2006; Faccio, 2006; Faccio, Masulis, and McConnell, 2006) by considering management turnover to control for the problems of ambiguous incorporated institutions or self-selection in prior research. A concern that arises in prior research, whether the pros to political connection as in Faccio et al. (2006) or cons to political connection as in Fan et al. (2006), is whether or not the political connections we observe come about because a firm is in need of an immediate political connection/capital. That is, the observed association between a political connection and its relevant effects may be a marriage of convenience in which the political connection is established for the specific purpose of seeking benefits. Management turnover cases provide a dynamic setting to examine the role of political executives in SOEs. Second, the findings provide a better understanding of government interests and their impact on corporate governance by examining managerial appointment decisions made by state owners of SOEs. Despite the 7

8 potential importance of managerial appointment decisions made by shareholders in prior research (Shleifer and Vishny, 1996; Huson et al., 2004; Denis and Denis, 1995; Bonnier and Bruner, 1989), there is very little direct evidence regarding the managerial role in corporate governance perceived and implemented by state owners (government) in a political economy. Further, most existing studies focus on the objectives of politicians and neglect the incentive problems of shareholders and managers in SOEs (Hellman and Schankerman, 2000; Fan et al., 2006). The examination of the relationship between the appointment of political executives in management turnover decisions and prior firm performance, and the consequences of such appointments provides an opportunity to better understand the interests of government when it is the major shareholder. Third, the findings contribute to the corporate governance literature by providing evidence of firm adaptation in political institutions, not as suggested prescriptions for governance structure modifications adopted for firm survival in prior studies (Shleifer and Vishny, 1996; Claessens and Fan, 2002). 3 The rest of the chapter proceeds as follows. Section 2 reviews the literature and introduces the background. Section 3 develops the hypotheses, distinguishing various views in context. Section 4 presents the research design, and Section 5 describes the data and sample. Section 6 reports the results and the robustness checks and Section 7 concludes the chapter. 3 Prior studies (Shleifer and Vishny, 1996; Claessens and Fan, 2002) suggest some external market mechanism such as bankruptcy or the takeover of failing firms. However, these external market controls are not applied in state-owned enterprises because of soft-budget constraints in these enterprises (Krueger, 1990; Qian and Gerard, 1996). 8

9 2 Literature Review and Background 2.1 Management Appointment and Firm Performance in Prior Studies The relationship between the appointment of executives and preceding firm performance directly reflects the role of appointed executives perceived by the shareholder(s) who made the appointment decision. Prior studies that are largely based on sample firms in market economy have established the theoretical framework of the relationship of the change and selection of managers and firm performance. This relationship has been the focus of a large and growing literature, as classical principal agent theory (e.g., Holmstrom, 1979) predicts that managers should be evaluated and selected using observable performance metrics that provide information concerning an individual s efforts or abilities. Early studies of management selection and performance conducted in the 1980s (Coughlan and Schmidt, 1985; Warner et al., 1988; Weisbach, 1988) provide much empirical evidence of various aspects of the management-performance relation. These studies have established the following. i) Improvement hypothesis: poor performance and managerial selection Firms in distress replace incumbent executives and appoint new executives because of the perceived inadequacies of the former (Schwartz and Menon, 1985). Pfeffer and Salancik (1978) point out that replacing executives can help to change both internal and external perceptions of company image and help restore confidence in a firm s future. Newly appointed executives, particularly those from outside the company, are expected to initiate changes in policy and existing patterns of 9

10 administrative and resource allocation, or embark on major transition programs for the firm (Guest, 1962; Helmich and Brown, 1972; Pfeffer, 1981; Dalton and Kesner, 1983). It has generally been concluded that following poor firm performance, newly elected executives play a helpful and monitoring role in firm survival and adaption. ii) Maintenance or self-benefit hypothesis: good performance and managerial selection There are fewer instances of CEO turnover following good firm performance. Intuitively, executives are promoted following such performance. For example, Morck, Shleifer, and Vishny (1988) find evidence that internal succession is sensitive to abnormally good performance because turnover is more of a reward to the current management team for especially good performance. Alternately, the CEO may decide to retire following good performance to increase his or her retirement benefits (Puffer and Weintrop, 1991). Despite the paucity of evidence, the implicit conclusion is that turnover following good performance is related to an executive s own career and benefits, and rarely to corporate survival. The successor is perceived to be able to at least maintain the corporate strategies or to be likely to grab rewards as did his or her predecessor. iii) No relationship: non-performance factors and managerial selection The appointment of executives could have nothing to do with performance, and be perceived to have no impact on corporate governance. For example, Brickley (2003) argues that the age of the CEO is more important in explaining CEO turnover than measures of firm performance. Cannella and Lubatkin (1993) suggest that social 10

11 relationships and political constraints moderate the relationship between performance and management decisions. 2.2 Political Economy Issues in China The findings on the relationship between top management appointment and firm performance remain inconclusive in a political economy such as that of China, where patterns of political leadership recruitment have been the focus of much research attention. On the one hand, scholars have doubts about the professionalism of political leaders in business and recruitment based on the performance hypothesis (Chen et al., 2002; Fan et al., 2006; Opper and Brehm, 2007). On the other hand, political control remains prevalent, probably in an optimal degree to some extent, in transitional economies due to poor corporate governance and weak legal protection for investors (Chang et al. 2004; Li, 2000; Qian, 1995, 1996; Xu et al. 2002). No external market for corporate control exists in the economy highly involved by government like China. As a result, most of China s listed firms lack external pressure that tie the manager s incentives to firm performance. The corporatization in SOEs, for example, employing an independent or professional manager, might not do the same effectiveness as in the market economy like the U.S. In addition, anecdotal evidence indicates that in some Chinese SOEs, the government would like to appoint a politician to replace the chairman of the board or CEO in its affiliated enterprises when the enterprises encounter troubles in firm performance. For example, in 2004, the local government 11

12 appointed Zhao Yong, who was the vice mayor of Mianyang in Sichuan Province, to the position of Chairman of Board in a local backbone state enterprise, Sichuan Changhong Electric Co. (SEC code: ), which had suffered huge losses following fraud and legal disputes with APEX Co. in the United States (see more examples in Appendix C). 4 Hence, compelling issues arise in a country such as China where the political economy is mixed with the market economy: first, is the appointment of political executives in SOEs performance based or non-performance/connection based? Second, what are the roles of these political executives in firm performance and corporate governance? The following hypotheses examine these issues. 3 Hypothesis Development 3.1 Appointment of Politically Connected Top Management and Preceding Firm Performance Relationship between Management Appointment and Firm Performance in China s SOEs Although prior studies of management appointment and firm performance are based on Western firms, which are usually diversified in shareholding and managed by professional managers, and the shareholders of which have consistent profit-maximization goals, it is appealing to apply this framework to investigate how 4 Referred to as news on the Internet. All news is in Chinese. 12

13 state owners in China perceive the role of top executives they appoint because the interests of a state owner (government) as both shareholder and politician are unsolved in the prior literature. 5 There are three views of government intervention in business: that the government can play a grabbing hand or helping hand role or has no effective influence on the economy (Shleifer and Vishny, 1998). The grabbing hand view holds that political executives appointed by government pursue objectives that run counter to corporate productivity and extract rents from firms (Shleifer and Vishny, 1994, 1998; Chang and Wong, 2002; Fan, Wong, and Zhang, 2006), whereas the helping hand view maintains that in the absence of large and active private investors and well-functioning institutions of corporate governance, the direct appointment of political executives is the most powerful way that government can constrain the abusive behavior of enterprise insiders and thus reduce agency costs (Qian, 2000; Li, 2000; Chang and Wong, 2004). The third view holds that the appointment of political executives is just window dressing, as politically affiliated directors are puppets of management (Agrawal and Knoeber, 2001, among others). Although some studies find evidence that political directors appointed by government can mitigate firm efficacy (Fan, Wong, and Zhang, 2006, among others), the Chinese government has strong incentives to promote economic performance for economic growth as it initiated reforms since 1980s. In particular, local government heavily relies on SOEs performance for fiscal revenues and lobbing positions in the central 5 In China, personnel control is centralized in the hands of the government. The State-owned Assets Supervision and Administration Commission (SASAC), authorized by state-level or local-level government, takes responsibility as an investor of state-owned assets on behalf of the central/local government, and one of its tasks is to select and appoint the management of state-owned enterprises. (Please refer to the Web page of the SASAC ( 13

14 government (Maskin et al. 2000; Qian, 1996, 2000). Based on these arguments and anecdotal evidence, the following hypothesis is developed to examine whether a state owner (government) perceives that political executives play a helping role (or other roles) in response to preceding poor firm performance or distress. Hypothesis 1 (H1): The appointment of political top executives in SOEs is positively associated with poor firm performance or distress The Influence of Government Involvement on the Relationship between Management Appointment and Firm Performance in China s SOEs As the government firmly controls key personnel appointments in SOEs, the management appointment into SOEs is ultimately determined by the interests of government for a business. The following discusses how SOE characteristics which embody government involvement influence the appointment of top executives by government. i) Concentration of government ownership A higher concentration of government ownership will presumably give the controlling shareholder more incentives to monitor management (La Porta et al., 2000). When the incumbent manager does a poor job, the controlling owner has a strong incentive to select the right person to ensure that management acts in his or her interests (Fama and Jensen, 1983; Jensen and Meckling, 1976). This leads to an increase in the number of appointments of political top executives in SOEs in 14

15 response to poor firm performance because they have more accountability to behave as the interests of state owners. Hence, the following hypothesis is posited. Hypothesis 2 (H2): Among SOEs with more concentrated government ownership, the likelihood of the appointment of political top executives associated with poor firm performance increases. ii) Jurisdictional level of government ownership There are several layers of government ownership: central, provincial, municipal, and county (please see details in Appendix B). Save for the central level, the other levels are called local government ownership. As central government ownership of such companies as energy or defense-related firms is considered key to national security, the central government maintains significant absolute or relative controlling stakes in these enterprises, and central government ownership occupies a substantial share of the economy. Hence, when central government enterprises are in distress, the government is more likely to appoint a political executive who performs political scrutiny and regulation roles in the firm, which leads to the following hypothesis. Hypothesis 3 (H3): Among SOEs with central government ownership, the likelihood of the appointment of political top executives associated with poor firm performance increases. 15

16 iii) Market power of SOEs The state is more responsive to the interests of certain firms that hold a monopolistic position (Chari and Gupta, 2006). Faccio (2007) argues that large firms may find political capital more valuable. Both the government and involved firms can benefit more from the support of monopolistic firms. Hence, when an SOE that has monopoly power is in distress, the state is more likely to appoint a political manager with invaluable political expertise to maintain the firm s monopoly power and performance. Hence, the following hypothesis is posited. Hypothesis 4 (H4): When SOEs with strong market power are in distress, the likelihood of the appointment of political executives increases. iv) Strategic SOEs Regarding the strategic industries, the government maintains absolute control of firms in these sectors and regulations supplant decisions normally made by managers through an administrative process. The regulatory process in strategic SOEs demands managerial expertise more related to the political process and regulatory procedures. Hence, the following hypothesis is posited. Hypothesis 5 (H5): When SOEs in strategic industries are in distress, the likelihood of the appointment of political executives increases. 16

17 3.2 Appointment of Politically Connected Top Management and Post-Appointment Firm Performance and Corporate Governance Post-appointment firm performance and governance is further examined because there are various views of their ex post role in corporate governance under government involvement, while the government appoints political executives based on its perception of how they can improve firm performance. Disciplinary/monitoring role. Some scholars believe that newly appointed political executives play a disciplinary or monitoring role in corporate governance to improve performance. That is, they are more efficient in initiating internal governance changes or mitigating the opportunistic behavior of managers, and substitute for external market pressure for corporate control (Boeker and Goodstein, 1993; Dalton and Kesner, 1985; Kaplan and Minton, 1994). Some studies find evidence of the monitoring efficacy of political managers. For example, Cannella and Lubatkin (1993) indicate that the social and political capital of executives gives them more power to deal with current critical contingencies, which enables them to influence internal governance decisions. Agrawal and Knoeber (2001) suggest that political executives have regulatory expertise and expertise in government procedures, which aids in internal governance and disciplining the actions of executive staff members by virtue of knowledge of government regulations and laws. Qian (1996), Li (2000), and Chang and Wong (2004) indicate that political executives behave in accordance with the state s interests and can mitigate managerial opportunism through the check and balance system instituted by politicians. Xu et al. (2005) suggest that politically 17

18 connected managers are more accountable to politicians and hence their ability to abuse their power is possibly curtailed. Agrawal, Jaffe, and Knoeber (1999) find that firms discovered to have violated governmental regulations are inclined to hire a new senior manager with political and regulatory connections, perhaps because the incumbent corporate officers have destroyed part of their reputational capital with regulators or because regulatory violation increases the sensitivity of the firm s performance to regulatory or political oversight, thus increasing the net benefits of having top executives with political and regulatory influence in corporate governance. Form of bailout. Other scholars argue that new political executives are appointed to SOEs as a form of government bailout, and do not reduce agency costs or discipline managers or employees. Kornai (1980) and Qian and Gerard (1996) find that loss-making SOEs are subsidized by the government or government-directed banks. Shirley and Walsh (2000) argue that politicians fail to credibly commit to ending subsidies to SOEs, given their incentives to use SOEs to pursue political goals. Krueger (1990) suggests that politicians tend to hire politically connected individuals rather than qualified individuals. Hence, people are concerned that political executives serve as a form of government bailout to ensure a company s survival, regardless of their capability or efficiency. Hence, the following hypothesis is provided to examine whether newly appointed political top executives play a helpful role, that is, whether post-appointment firm performance is improved (in alternative form). 18

19 Hypothesis 6 (H6): The appointment of politically connected top management is positively associated with a subsequent change in firm performance. However, even if post-appointment firm performance does improve, the bailout hypothesis argues that political top executives just play an insurance role for government assistance, and are not capable of running corporate operations efficiently. Hence, the following hypothesis examines whether newly appointed political top executives are able to initiate or improve internal governance, that is, whether post-appointment corporate governance is improved (in alternative form). Hypothesis 7 (H7): The appointment of politically connected top management is positively associated with a subsequent change in internal corporate governance. 6 4 Research Design 4.1 Measures Executive political background Given the dual presence of the communist party and government organs at each level of China s political hierarchy (Whiting, 2001), a chairman of the board or CEO 6 I do not conjecture here that internal governance initiates good changes or bad changes with the assumption that the governance changes accompanying improved firm performance are good. 19

20 is identified as someone having political expertise or a political background if i) he or she has had experience working in state-level or local-level government entities (including the military); or ii) has had one of three main party positions Party Secretary, Central Committee Member, or Representative of the National People s Congress. In the final sample, the appointment of a political executive is defined as either a chairman or CEO who has been newly appointed and has either of the political backgrounds described above. Poor firm performance (distress) This study focuses on two kinds of distress to measure firm performance: economic distress and political distress. The data for measuring distress are obtained from CSMAR. The three measures for economic distress are: i) accounting firm performance (ROA) (suggested by EHW, 2003; Chang and Wong, 2006; Kato and Long, 2006) 7 ; ii) earnings loss, a dummy variable equal to 1 if net income is less than zero; and iii) financial distress, debt to assets ratio (DA) for leverage risk (suggested by Gilson, 1990, among others). The measure for political distress is a dummy variable for the firm year during which the company violated regulations or laws disclosed by the SEC of China (suggested by Sun and Zhang, 2006; Agrawal, Jaffe, and Karpoff, 1999). 7 An alternative measure in the prior literature is firm market performance (stock price). However, Chang and Wong (2006) suggest that managerial change and selection in Chinese SOEs is not significantly associated with stock price performance because state-owned shares are usually non-tradable and can only be transferred following administrative approval. The SASAC or bureaucrats, who exercise control on behalf of the government, are unable to personally capture any capital gains when enterprise shares are transferred. Consequently, state owners may also be less concerned about shareholder long-term value as reflected in stock prices. This study also conducts the test using stock price performance. The results show no significant association. 20

21 SOE characteristics i) Concentration of government ownership: proportion of shareholdings owned by the government; or a dummy variable equal to 1 if the proportion of government shareholdings is above the median government ownership. ii) Jurisdictional level of government ownership: dummy variable equal to 1 for central government ownership, and 0 for local government ownership. iii) Market power of an SOE: MS : percentage of firm i s sales to the total sales of all firms in the municipal unit in which it is located. L arg e _ Market : dummy variable equal to 1 if firm i s sales are above the median level of those of all firms in the provincial unit in which it and its regional competitors are located, and 0 otherwise. iv) Strategic SOE Strategic : dummy variable equal to 1 for an SOE in a regulated or strategic industry based on the SIC code issued by the Chinese SEC, including the defense, power generation and distribution, oil and petrochemical, telecommunications, coal, aviation, and shipping industries. 4.2 Model To test the relationship between management appointment and preceding firm performance, the LOGIT model is applied as follows. 21

22 Logit ( Appoint ment) = α + β1 * Performance it + β 2 * CV it + ε it, where Appo int ment = 1 if the incumbent top executive, the chairman or CEO, is replaced by a politically connected top executive, and 0 otherwise; and Performanc e = the four performance measures described in Section The control variables ( CV it ) include: ROA ( t 1) : previous firm performance; Log (Assets) : control for firm size; Log (Employee) : control for the number of employees because the SOE or politician has a social goal of employment; Log (GDP) : control for the economic conditions of labor markets in various regions; Indus _ MB : industry median market-to-book ratio by 2-digit SIC code, a surrogate for the investment opportunity set (IOS). Prior research indicates that the IOS may also be associated with management turnover because firms with a high degree of IOS demand high-quality managers (Smith and Watts, 1992); and Pr e _ pro : a dummy variable if the previous top executive, the chairman or CEO, has no political background or experience. To test the interaction of the relationship between management appointment and preceding firm performance with characteristics embodying government involvement, the LOGIT model is applied as follows. 22

23 Logit( Appoint ment) = α + β * Performance + β * CV 3 it + ε it 1 it + β * Performance 2 it * Characteristics, where the variables are described as above and firm characteristics is measured as in Section 4.1. To examine post-appointment firm performance and corporate governance, variable descriptions and statistics surrounding the event are compared. 5 Data and Sample 5.1 Data For this study, the data of senior manager (chairman and CEO) changes in all listed firms from 2001 to 2005 are obtained from the China Securities Markets and Accounting Research (CSMAR) database. Information about the backgrounds of chairmen, CEOs, and companies is collected by reading annual reports or summaries of top management resumes published on the following finance Web pages: or The CSMAR database serves as the primary source for the financial data used in the study. A number of firms are excluded from the sample. Non-state firms are excluded from the sample because the motivation of private owners in selecting top management, which is not the focus of this study, is different from that of state owners. Also excluded are firms in which the incumbent chairman or CEO leaves because of the natural reasons identified in Chapter 2: i) natural retirement or expiration of an acting position; ii) health reasons; iii) change of ownership, for 23

24 example, privatization; and iv) resignation. As well, firms without any information on their ultimate controlling shareholders and/or financial information and financial institutions (1-digit SIC code: I) are excluded. 8 The final sample includes 696 listed state-owned enterprises in China from 2001 to Sample Description Table 1 (a) describes the distribution of all appointed top executive political backgrounds in the final sample. The final sample consists of 3069 firm years, among which 682 firm-year observations that experience a change of either the incumbent chairman of the board or CEO and select a new one. More than half of newly appointed chairmen or CEOs have a political background, 53% of whom have experience working in various government entities and 79% of whom have experience in various party positions (some have overlapping experience in the period considered). Looking only at the sample of chairmen, Table 1 (b) shows that 369 firm-year observations appoint new chairmen, of whom 65% have a political background. Looking only at the sample of CEOs, Table 1 (c) shows that 493 firm-year observations appoint new CEOs, of whom 38% have a political background. Overall, a state owner values the political background of an executive when selecting a new executive, and values such a background more in a chairman than in a CEO. 9 [Table 1] 8 The SASAC s mandate does not cover financial organizations. Supervision of financial institutions is the responsibility of the Central Banking Supervisory Committee (CBRC). In financial institutions, ownership and regulatory functions are more clearly separated. 9 Anecdotal evidence indicates that the chairman in Asia has the ultimate decision rights in corporate operations. 24

25 Table 2 describes the distribution of overall turnover, appointment of political top executives, and performance variables by one-digit industry. As shown in the table, industries such as agricultural production (A), heavy construction (E), and wholesale and retail trade (H) have a higher frequency of appointment of political executives, compared with the overall mean frequency of 0.12, and the performance of firms in these industries is poorer than the overall means. For example, in industry A, agricultural production, 18% of firms appoint new political executives (larger than the overall mean of.12). Although the mean DA (0.45) is little bit lower than the overall mean (0.47), other performance variables are poorer than the overall means: 12% of firms record losses (larger than the overall mean of.10), the mean ROA (0.01) is lower than the overall mean (0.02), and 12% of firms violate regulations (much larger than the overall mean of.04). In contrast, industries such as mining (B), manufacturing and petrochemicals (C), transportation (F), and others (M) have a lower frequency of appointment of political executives, compared with the overall mean of 0.12, and the performance of firms in these industries is better than the overall means. Even more interesting, regulated industries including power, oil, and water (D), real estate (J), infrastructure and social services (K), and media and communications (L) have a higher frequency of appointment of political executives, whereas the performance of firms in these industries is relatively better than the overall means or they have less frequency of earnings loss or regulation violation. These results imply that a state owner has reasons other than (poor) performance to appoint political executives in these industries. 25

26 [Table 2] Figure 1 draws the appointment pattern across 10 years from 1996 to 2005, benchmarked with the status of firm performance/distress. The frequency of appointment of political executives (top first line) increases gradually across 10 years with gradually increasing frequency of earnings loss, regulation violation, and mean debt-to-assets ratio. The figure provides dirty and direct evidence that the changing pattern of the appointment of political executives is consistent with the distress status of firms. [Figure 1] Figure 2 plots the frequency of appointment of political executives by the mean GDP of various areas. 10 Generally, the frequency of appointment of political executives is inversely distributed with the wealth of the area. The poorest area, the Northwest, has the highest frequency of appointment of political executives, and the richest area, the East, has the lowest frequency of appointment of political executives. This suggests that the labor market in poorer areas is less competitive and more competitive in richer areas. [Figure 2] 6 Empirical Results 10 Referring to the Government Yearbook, China is partitioned into six administrative areas: North, consisting of five provincial units (Beijing, Tianjing, Heibei, Shanxi, and Inner Mongolia); Northeast, consisting of three provincial units (Liaoning, Jilin, and Heilongjiang); East, consisting of seven provincial units (Shanghai, Jiangsu, Zhejiang, Anhui, Fujian, Jiangxi, and Shandong); Southcentral, consisting of six provincial units (Henan, Hubei, Hunan, Guangdong, Guangxi, and Hainan); Southwest, consisting of five provincial units (Chongqing, Sichuan, Guizhou, Yunnan, and Tibet); and Northwest, consisting of five provincial units (Shanxi, Gansu, Qinghai, Ningxia, and Xinjiang). 26

27 6.1 Results for the Appointment of Politically Connected Top Management and Preceding Firm Performance Table 3 provides the descriptive statistics of the appointment of political directors in distressed and non-distressed firms. Panel A partitions the sample into loss and no-loss groups according to negative net income. The loss firms change their chairman or CEO more frequently than do no-loss firms, consistent with the prior literature, which is evidence of the higher management turnover rate following poor performance as a disciplinary mechanism (Warner et al., 1988; Coughlan and Schmidt, 1985; Weisbach, 1988). Whereas 19% of loss firms select and appoint a new executive who has a political background, only 12% of no-loss firms select a new political executive. This finding indicates that loss firms select significantly more political executives than do no-loss firms. Panel B partitions the sample into two groups based on whether or not a firm violates regulations/laws. Whereas 20% of violation firms select and appoint a new executive who has a political background, only 12% of no-violation firms select a new political executive. Panel C partitions the sample into high debt-to-asset ratio and low debt-to-asset ratio groups. The results show that high-da firms select significantly more political executives than do low-da firms. Univariate analysis supports the regulatory expertise hypothesis. [Table 3] Table 4 presents the logistic regression of overall replacement of top executives associated with preceding firm performance. Consistent with previous studies (Groves et al., 1995; Chang and Wong, 2002), the results show that overall management 27

28 turnover in Chinese SOEs, independent of executive origin, increases significantly with poor firm performance/distress. [Table 4] Table 5 presents the logistic regressions with the dummy variable for the appointment of political/non-political executives as chairman of the board or CEO as the dependent variable. Various variables for firm distress are the main independent variables. The control variables include: Firm Size ( Log( Assets) ); Ownership Concentration (percentage of shareholdings the ultimate state owner holds), a proxy for the control rights of the state owner; Employment ( Log(Employee) ), a control for the number of employees because the SOE or politician has a social goal of employment; Region Variety ( Log(GDP) ), a control for economic and labor market conditions; the industry median market-to-book ratio ( Indus _ MB ) by 2-digit SIC code, a surrogate for the investment opportunity set (IOS); a dummy variable ( Pr e _ pro ) that measures whether the previous top executive, the chairman or CEO, has a political background or experience. Year and industry dummies are included in the regressions, but for the sake of brevity, their results are not reported in the table. Table 5 (a) presents the regression results for the appointment of executives who have a political background (378 observations), which is significantly negatively associated with firm accounting performance (ROA) of the current period (coefficient is and p-value is 0.004) and lag period (coefficient is -1.1 and p-value is 0.011). The appointment of these executives is also significantly positively associated with the earnings loss dummy (coefficient is 0.71 and p-value is <.0001), regulation violation 28

29 dummy (coefficient is 0.54 and p-value is 0.028), and debt-to-asset ratio (coefficient is 0.87 and p-value is 0.009). Among the control variables, only Ownership Concentration is significantly and positively associated with the appointment of political executives, which suggests that the greater are the control rights of a state owner, the more likely it is to value political expertise. [Table 5 (a)] For comparison purposes, Table 5 (b) presents the regression results for the appointment of executives who have no political background. A total of 304 firm-year observations selected a chairman or CEO who has neither government nor party political experience. In contrast to the results for the appointment of political top executives, the appointment of non-political executives is not significantly associated with firm distress, that is, ROA, earnings loss, high degree of financial risk, or regulation violation. Only firm size has a significantly negative effect on the selection of non-political executives, which suggests that a state owner is more likely to appoint non-political executives to smaller SOEs. [Table 5 (b)] The regression results support the regulatory expertise hypothesis that a state owner prefers executives to have political expertise when firms are in distress. 6.2 Results for Management Appointment and Preceding Firm Performance Interacted with SOE characteristics We next test the likelihood of the appointment of top executives associated with 29

30 firm performance and the interaction between firm performance and SOE characteristics. Table 6 reports the results for the interaction between firm performance and concentration of government ownership. Table 6 measures the concentration of government ownership by a dummy for the proportion of shareholdings held by government above the median level of the year. The coefficient of the interaction term of various firm performance measures and ownership concentration is still insignificant, except that the interacted effect of firm accounting performance and ownership concentration ( Own * ROA( t) ) is significantly positive. This result appears to contradict hypothesis 2 (H2) because a positive coefficient suggests that for a SOE with more concentrated government ownership, the inverse relationship between the likelihood of appointing a political top executive and firm accounting performance is weaker. It is interpreted that among SOEs with more concentrated government ownership, the appointment of political top executives may be less likely to be caused by performance than other factors. Alternatively, we define the concentration of government ownership as the proportion of shareholdings held by government (the results are not reported in the table). The coefficient of the interaction term of various firm performance measures and ownership concentration is insignificant. [Table 6] Table 7 reports the results for the interaction between firm performance and jurisdictional level of government ownership, using the central enterprise as a dummy variable to interact with poor firm performance. The findings show that if the SOE is 30

31 a central enterprise, then the likelihood of the appointment of a political executive increases by 5.11 (p value = 0.072) sensitive to declining accounting performance; that is, the coefficient of ROA becomes even more negative. In response to earnings loss, the likelihood increases by 0.81 (p value = 0.065). In response to increasing financial risk, the likelihood does not change significantly. When a central SOE violates regulations/laws, it is more likely to appoint a political executive (the coefficient of the interaction term increases by 0.83), but the likelihood is not significant. The results provide some support for the hypothesis that if an SOE is a central enterprise, then the state is more likely to appoint a political executive if that enterprise is in distress. [Table 7] Table 8 reports the results for the interaction between firm performance and market power of SOEs. Table 8 measures the market power of an SOE by the percentage of its sales higher than the median level in the provincial unit in which it is located. The sign of the coefficient of the interaction term of regulation violation and market power is positive and significant (+1.38; p value = 0.020), which suggests that among SOEs with a higher percentage of market sales and which violate regulations or laws, the likelihood of the appointment of a political top executives increases significantly. The sign of the coefficient of the interaction term of other firm performance measures and market power supports hypothesis 4 (H4), but is not significant. Alternatively, we measure the market power of an SOE by a continuous variable which is defined as the percentage of its sales in the provincial unit in which 31

32 it is located (the results are not reported in the table). The coefficient of the interaction term of various firm performance measures and market power is insignificant. However, the sign of the coefficient shows that among SOEs with a higher percentage of market sales, the likelihood of the appointment of a political top executive increases in response to poorer firm performance. [Table 8] Table 9 reports the results for the interaction between firm performance and strategic SOEs. A strategic SOE is represented by a dummy equal to 1 if the SOE is in a strategically important industry (defense, power generation and distribution, oil and petrochemicals, telecommunications, coal, aviation, and shipping). The results show that the interaction terms have no significant effect. The signs of the coefficients of the interaction terms contradict hypothesis 5 (H5), which suggests that among strategic SOEs, the inverse relationship between the appointment of political top executives and firm performance is weaker. Interpreted based on ownership concentration, the appointment of political top executives in firms in a strategic industry may be less likely to be caused by performance factors. [Table 9] 6.3 Results for Management Appointment and Post-Appointment Firm Performance and Corporate Governance In this section, we investigate what changes the appointment of politically connected top management brings to SOEs by examining operating performance and 32