How Corporate Scandals Affect Political Ties & Market Credibility

ZHANG, Fang | WONG, T.J. | HUNG, Mingyi

A manager bribes government officials; a manager of a state-owned enterprise misappropriates its assets; accounts are manipulated to inflate earnings… How do corporate scandals such as these affect a company’s value in terms of political ties and market credibility – and what is the relative importance of these two factors?

While previous studies have focused on the effects of either political ties or market credibility on value,

Mingyi Hung, T.J. Wong and Fang Zhang sought to compare the value of one versus the other, and to focus on emerging economies where governments exert significant control on markets. They chose China for three reasons: it has prevalent state-connected enterprises and a relatively high frequency of corporate scandals; like other emerging economies there are competing political and economic forces that shape the relative importance of political ties and market credibility; and as the world’s second largest economy, it provides rich market depth. Government control over the corporate sector in the Mainland remains strong, and political ties enable state and non-state firms to engage in implicit and explicit contracts, ranging from capital financing and operational contracts to direct subsidies. Scandals that lead to the destruction of these ties reduce value by harming future opportunities for government contracts. However, the growth in market infrastructure, legal institutions and regulations has resulted in more market-based contracts among listed firms, making market credibility increasingly important.

The research team hypothesized that that scandals signaling the loss of political ties have a greater negative effect on firm value than scandals signaling the loss of market credibility. But as recent economic reforms have shifted the country from political-based to more market-based contracting, market credibility may be just as important -- if not more important -- than political ties.  They tested this using a sample of 236 corporate scandals that took place between 1997 and 2005 and resulted in enforcement actions by the Chinese courts and securities regulators. The scandals were divided into three categories: political; mixed political and market-related; and market scandals.

They discovered that political and mixed scandals were associated with worse stock returns than market scandals. The greater negative market reactions associated with these two categories were primarily driven by firms that rely more on political networks – suggesting the Chinese economy is more political-based. These firms experienced a larger decrease in operating performance and loans from state-owned banks, and saw greater destruction of their political networks, reflected in movement in and out of political directors.

The research is significant because it was the first to compare the price effects and other economic consequences of scandals that signal the destruction of political ties versus scandals that flag up the destruction of market credibility. It also complements prior research of political ties by focusing on both the net benefits and costs of losing political ties. Contrary to other research that the possession of political ties negatively affects post-IPO stock returns of Chinese firms, this team found that the destruction of political ties is associated with a decline rather than a rise in firm value. The finding suggests that while scandal-hit firms in China likely still bear the costs from excessive government control and intervention, they lose their expected benefits and rents from state loans and other government contracts.

HUNG, Mingyi

Head, Fung Term Professor of Accounting, Chair Professor