Product market competition,ultimate controlling structure and related party transactions

Shenglan Chen,Kun Wang,Xiaoxue Li

aDepartment of Accounting,School of Economics and Management,Inner Mongolia University,China

bDepartment of Accounting,School of Economics and Management,Tsinghua University,China

cDepartment of Accounting,School of Management,China University of Mining and Technology,China

Product market competition,ultimate controlling structure and related party transactions

Shenglan Chena,*,Kun Wangb,Xiaoxue Lic

aDepartment of Accounting,School of Economics and Management,Inner Mongolia University,China

bDepartment of Accounting,School of Economics and Management,Tsinghua University,China

cDepartment of Accounting,School of Management,China University of Mining and Technology,China

A R T I C L EI N F O

Article history:

Accepted 7 November 2012

Available online 3 December 2012

JEL classification:

G32

G34

L14

Product market competition

Ownership structure

Ultimate controlling shareholder

Cash flow rights

Related party transactions

Previous studies have shown that product market competition has an important effect on corporate strategies and internal governance mechanisms.Using a sample of China's listed firms from 2004 to 2009,we explore the relationship between product market competition and normal related party transactions and find a significant positive relationship.In addition,we investigate the substitutive effect of product market competition and the cash flow rights owned by ultimate controlling shareholders on the extent of normal related party transactions.In particular,our results suggest a positive relationship between the ultimate controlling shareholders'cash flow rights and normal related party transactions that is strongest in noncompetitive industries and weakens as product market competition increases.

?2012 China Journal of Accounting Research.Founded by Sun Yat-sen University and City University of Hong Kong.Production and hosting by Elsevier B.V.All rights reserved.

1.Introduction

Product market competition plays a pivotal role in influencing corporate strategies and internal governance mechanisms.Shleifer and Vishny(1997)argue that“product market competition is probably the mostpowerful force towards economic efficiency in the world.”Competition increases the probability that firms with high costs will go bankrupt(Schmidt,1997)and fear of bankruptcy is a strong incentive for managers to exert the effort required to remain competitive(Hart,1983).Further analysis shows that product market competition is a substitute for internal governance that reduces agency costs(Karuna,2010;Giroud and Mueller,2011).

The role of related party transactions(RPTs)within business groups is widely discussed in the literature. Efficiency-enhancing theory suggests that imperfect emerging markets increase transaction costs that can be largely reduced through RPTs between the members of a business group(Khanna and Palepu,1997,2000). In contrast,agency theory argues that RPTs can be used in the expropriation of listed companies.In particular,business groups could use abnormal RPTs to tunnel resources from listed firms(Liu et al.,2008;Chang and Hong,2000).

Following these studies,particularly the methodology of Jian and Wong(2010),we classify RPTs as normal or abnormal.Normal RPTs can decrease the transaction costs of listed firms,whereas abnormal RPTs can be used as a way of tunneling or propping business groups'specific purposes.According to the efficiency-enhancing view,normal RPTs help firms to reduce transaction costs and increase value.This implies that product market competition leads to a greater need for normal RPTs to reduce transaction costs.Given that controlling shareholders with substantially more cash flow rights have strong incentives to maximize firm profits through normal RPTs(Shleifer and Vishny,1986),we expect to observe a substitution effect between product market competition and controlling shareholders'cash flow rights.

Our empirical evidence is consistent with these predictions.Using a sample of China's A-share listed firms from 2004 to 2009,we show that product market competition has a significant positive effect on normal RPTs. That is,firms from more competitive industries tend to reduce transaction costs by increasing normal RPTs. We also find that product market competition and ultimate controlling shareholder's cash flow rights have a substitutive effect on normal RPTs.Specifically,we note a positive relationship between ultimate controlling shareholders'cash flow rights and normal RPTs.Moreover,this relationship is strongest in noncompetitive industries and weakens as product market competition increases.

Our study contributes to the literature in the following ways.First,it adds to the rapidly expanding work on the effects of product market competition.For example,Aghion et al.(2006)investigate the relationship between product market competition and vertical integration.Our results suggest that product market competition also affects firms'transactions,i.e.firms from more competitive industries are more likely to have normal RPTs that reduce transaction costs.Second,our study has an important implication for research on ultimate controlling shareholders.Previous studies have mainly investigated the tunneling of ultimate controlling shareholders based on agency theory,ignoring the alignment of interests between controlling shareholders and other investors.Our results provide evidence that the cash flow rights of ultimate controlling shareholders have a positive effect on firms.Finally,we shed light on the relationship between external and internal corporate governance.Previous studies have shown that product market competition can either complement or substitute for some internal corporate governance mechanisms(Karuna,2010;Giroud and Mueller,2011).Our findings support the substitution effect by showing that the influence of ownership structure on the occurrence of normal RPTs is weakened by product market competitiveness.

The remainder of this paper is organized as follows.Section 2 develops the hypotheses and discusses the related empirical predictions.Section 3 discusses methodological and empirical issues.Section 4 presents our empirical results and Section 5 concludes the paper.

2.Literature review and hypothesis development

2.1.Product market competition and RPTs

Previous studies have shown that product market competition is pivotal in influencing firm profitability and corporate strategy.While earlier literature speculates that insufficient competition leads to managerial slack, Hart(1983)formalizes the idea that product market competition reduces managerial slack.In contrast,Raith (2003)argues that competition induces firm exit,which creates higher cost reduction incentives for the remaining firms.Following this,numerous studies have examined the economic consequences of competitionin product markets.For example,Schmidt(1997)shows that increasing competition not only increases firms' liquidation probability and managerial incentives,but also reduces their profit.Nickell(1996)finds that increased product market competition is associated with higher productivity growth in a sample of UK manufacturing firms.

Our study investigates the effect of product market competition on RPTs,which are common in Chinese listed companies due to the special institutional setting in China.A large number of Chinese listed firms have been restructured from existing SOEs through“carve-outs”and they retain a huge amount of transactions with members in their business groups.The role of RPTs and their determinants have been widely discussed in previous studies.According to the“efficiency-enhancing view,”the absence of institutions makes it costly for emerging market firms to acquire necessary inputs such as finance,technology and management talent.In this context,a firm may be most profitably pursued as part of a large,diversified business group that can act as an intermediary between individual firms and imperfect markets(Khanna and Palepu,1997,2000).Zheng et al.(2007)suggest that the efficiency effect dominates internal markets and increases firm value.1Zheng et al.'s(2007)conclusion is made when the ratio of internal product transactions to total assets is below 20%or above 50%.Ma and Wang(2009)use the results of a case study conducted at Shanghai Fu-Shing Inc.to determine that RPTs can be an effective means of efficient resource allocation.

However,RPTs can also be used as a means for controlling shareholders to satisfy particular needs.The“tunneling”view argues that the operation of RPTs in business groups provides a convenient channel through which controlling shareholders can transfer resources at the expense of minority shareholders in listed firms (Chang and Hong,2000;Cheung et al.,2006).Using a sample of China's listed firms,Jian and Wong (2010)reveal that abnormal RPTs are used by controlling shareholders to obtain private benefits.In sum, RPTs can be classified as normal or abnormal.Normal RPTs decrease the transaction costs of listed firms, whereas abnormal RPTs act as a way of tunneling and propping up a business group's specific needs.Therefore,following Jian and Wong's(2010)approach,we exclude abnormal RPTs and examine the relationship between product market competition and normal RPTs.

Transaction cost theory suggests that product market competition increases uncertainty,thus increasing the likelihood of vertical integration(Williamson,1975,1985).Aghion et al.(2006)argue that more competition increases the likelihood of vertical integration in sharing innovation benefits.Firms can benefit from an increase in normal RPTs in at least two ways.First,firms in competitive industries have higher bankruptcy risk than those in noncompetitive industries.This implies that firms in competitive industries can increase normal RPTs to reduce transaction costs,which can partially mitigate their bankruptcy risk.Second,product market competition may foster innovation and growth,allowing firms in competitive industries to share their innovation surplus with other member firms in the business group through normal RPTs.Therefore,we anticipate that product market competition is positively related to normal RPTs.

Hypothesis 1.Product market competition is positively related to normal RPTs.

2.2.Product market competition,ultimate controlling structure and related party transactions

Controlling shareholders can play a role in effectively monitoring the activities offirm managers,alleviating the free-rider problem associated with dispersed shareholders(Shleifer and Vishny,1986).Some researchers have examined the relationship between the cash flow rights of the ultimate controlling shareholder and corporate valuation(La Porta et al.,2002;Lins,2003).Bertrand et al.(2002)investigate Indian business groups and find that their owners are often accused of expropriating from minority shareholders by tunneling resources from firms in which they have low cash flow rights to firms in which they have high cash flow rights. More recently,Lin et al.(2011)explore 3468 firm-year observations in 22 countries from 1996 to 2008 and find that the cost of debt financing is significantly lower for companies with large ultimate owner's cash flow rights. Some researchers who have focused on China's capital market have also found that firms in which the controlling shareholder has higher cash flow rights or lower separation between ownership and control exhibit higher operating performance.For instance,Tong and Wang(2007)find that controlling shareholderspursue the advantages of shared benefits through RPTs when their proportion of shareholdings is more than 50%.

Recent studies have suggested that product market competition and internal corporate governance mechanisms are substitutes.For example,Karuna(2010)argues that product market competition can affect the strength of some internal governance mechanisms by influencing the costs and benefits of monitoring,given that competition acts as an important disciplinary mechanism in firm leadership.Giroud and Mueller(2011) examine the interaction between product market competition and corporate governance and find that weak governance firms have lower equity returns,inferior operating performance and lower firm value,but only in noncompetitive industries.More recently,Chhaochharia et al.(2012)use the Sarbanes Oxley Act as a natural experiment to explore the ways in which it shocked internal governance,examining the link between product market competition and internal governance mechanisms.Consistent with the notion that product market competition is a substitute for internal governance,they also find that firms in noncompetitive industries experienced a larger improvement in operational efficiency after the approval of SOX than firms in competitive industries.

Given the abovementioned literature,we focus on how product market competition and the ultimate controlling structure influence normal RPTs.Product market competition acts as an important disciplinary mechanism,influencing the overall costs of monitoring.Firms in competitive industries have incentives to use normal RPTs to reduce transaction costs.This implies that the influence of controlling shareholders is smaller in firms in competitive industries.In contrast,the association between ultimate controlling shareholders'cashflow rights and normal RPTs offers a stronger incentive for firms in noncompetitive industries to lower transaction costs.Our second hypothesis is as follows:

Hypothesis 2.The influence of the ultimate controlling shareholder's cash flow rights on normal RPTs is stronger in firms in noncompetitive industries than in firms in competitive industries.

3.Research design

3.1.Sample and data

The China Securities Regulatory Commission promulgated the“Regulation on the Content and Format of Information Disclosure of Firms with Public Equity Offerings No.2”on December 13,2004.Chinese listed companies have been required to disclose a block diagram of the title and control relationship between the company and the actual controller since 2004.To adjust for the potential measurement bias of the ultimate controlling structure,our sample period covers 2004-2009 in China's A-share market.After eliminating financial companies,securities companies and companies with unavailable data,we obtain a sample of 5954 observations.The ultimate controlling shareholder's cash flow rights variable is hand-collected and other financial variables are obtained from the China Securities Market and Accounting Research(CSMAR)database.

3.2.Variables

3.2.1.Product market competition variables

Following the literature,we measure product market competition using three variables:the number of market participants in an industry(Num),the concentration ratio(CR4)and the Herfindahl-Hirschman Index (HHI)(Curry and George,1983;Haushalter et al.,2007;Karuna,2007;Li,2010).“Num”is defined as the total number of companies in an industry.The number of market participants in the industry has a direct bearing on issues of concentration and competition.“CR4”measures the proportion of industry share for the four largest firms.This measure is easy to interpret and indicates the market share(concentration)of the four largest companies composing the industry,the maximum being 100%(monopoly).“HHI”is defined as the sum of the squares of the percentage shares of each company in relation to the total size of the industry. A higher value of HHI indicates stronger product market competition.

3.2.2.Ultimate controlling shareholder's cash flow rights variables

The manually collected ultimate controlling structure variables include the cash flow rights proportion,voting rights held by the controlling shareholder and voting rights held by other top-10 shareholders.Following LaPorta et al.(1999),the ultimate controlling shareholder's cash flow rights are computed as the product of that owner's cash-flow rights at each tier of the control chain(in some cases,more than one control chain linked an ultimate owner to a firm at the bottom of a pyramid).In addition,we consider relationships between the top 10 shareholders and their combined ownership positions.If the block diagram disclosed in the annual report does not publish information on known shareholder relationships,then we amend the block diagram and use it to calculate the ultimate controlling shareholder's cash flow rights variable(CashR).

Based on the above analysis,“CashR”is the product of the owner's cash-flow rights at each tier of the control chain.A higher CashR indicates better alignment of interests between ultimate controlling shareholders and other investors.

3.2.3.Normal related party transaction variables

RPT data is taken from the CSMAR related party transaction research database.There are many types of RPTs between listed firms and their business groups,including sales and purchases of goods and products, accounts receivable and accounts payable,the exchange of assets,loans or loan guarantees.We include related party sales and purchases as our measure of related party transactions,as sales and purchases are the most frequent type of RPT(e.g.Liu and Liu,2007;Hong and Xue,2008).Furthermore,RPT is separated into three categories:sales and purchases of goods and services(RPT),purchases of goods and services(RPT_Purc),and sales of goods and services(RPT_Sale).“RPT”is measured as the sum of related purchases and sales divided by total sales.“RPT_Purc”is measured as the sum of related purchases of goods and services divided by total sales.“RPT_Sale”is measured as the sum of related sales of goods and services divided by total sales.

We adopt Jian and Wong's(2010)approach to estimate normal RPTs.They use an OLS regression model to obtain the abnormal component of RPTs that are associated with industry classifications and firm characteristics such as leverage,size and growth.The residual term is the measure of abnormal related party transactions and the predicted term is normal related party transactions.This model is widely used in recent related party transaction research(e.g.Yeh et al.,2012).The following model is used:

We run three sets of year-by-year(2004-2009)regressions,one each for RPT,RPT_Purc and RPT_Sale as the dependent variables.The results are summarized in Appendix A.Furthermore,since our conclusions are largely dependent on the validity of the model,we examine the correlation between RPTs and firm performance.RPT is decomposed into normal and abnormal RPTs and the results show that normal RPTs are positively correlated with firm performance as measured by ROA,ROE or ROS.Abnormal RPTs are negatively correlated with firm performance.These results are summarized in Appendix B.

Referring to Jian and Wong(2010),our control variables include Lev,measured as total debt over total assets;Size,measured as the natural logarithm of total assets;and MTB,measured as the market value divided by the book value of total equity at year-end.

3.3.Research model

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To test Hypothesis 1,the following model is used:

PMC is represented by three variables:Num,HHI and CR4.The relationship between PMC and RPT may be non-monotonic.Therefore,we rank firms according to their PMC and then sort them into PMC quintiles. PMC_H is a dummy variable that is assigned a value of 1 when competition is in the highest quintile,and 0 otherwise.PMC_L is a dummy variable indicating when PMC lies in the lowest quintile of its empirical distribution.In response to Jian and Wong(2010),we add PROS as an important control variable that is measured as the return on sales of the firm 1 year before the related party transaction occurs.

To explore the effect of the interaction between the ultimate controlling shareholder's cash flow rights (CashR)and product market competition(measured by PMC,or PMC_H and PMC_L),the following model is used.If product market competition and the ultimate controlling shareholder's cash flow rights are substitutes,then the coefficient of the interaction term will be negative.

In the presence of clustered errors,OLS estimates are still unbiased but standard errors may be incorrect, leading to incorrect inference in a surprisingly high proportion offinite samples(Petersen,2009).Given this, we use standard errors clustered at the firm level for all of our regressions.The main variables are presented in Table 1.

4.Empirical analysis

4.1.Descriptive statistics of product market competition variables

All of the variables in the regressions are winsorized at the top and bottom 1 percentile across years to control for the potential influence of outliers.The final sample consists of 5954 firm-years,spanning the period from 2004 to 2009.We present the descriptive statistics of product market competition variables in Table 2 and use three different variables to measure the extent of product market competition.There is a significant difference in product market competition between industries.The variable Num shows that the most competitive industries are Equipment and Instrument Manufacturing(C7);Petroleum,Chemical,Plastics and Rubber Products Manufacturing(C4);and Metal and Non-metal(C6).The variable CR4 shows that the most competitive industries are Equipment and Instrument Manufacturing(C7);Medicine and Biological Products (C8);and Textile,Apparel,Fur and Leather(C1).The variable HHI shows that Equipment and Instrument Manufacturing(C7),Medicine and Biological Products(C8)and Textile,Apparel,Fur and Leather(C1)arethe top three competitive industries.In summary,the descriptive statistics are almost the same using our various proxy measures of product market competition.

4.2.Descriptive statistics of normal RPT variables

Table 3 shows the variables'descriptive statistics.The mean(median)value of NRPT is 0.170(0.176).After distinguishing the direction of RPTs,the results suggest that the mean(median)value of NPRT_Purc is 0.098(0.098),and the mean(median)value of NRPT_Sale is 0.098(0.100).The variable Num measures the total number of companies in an industry and has a value ranging from 63 to 269.

4.3.Correlation analysis

Person's correlation coefficients for the main variables in our analysis are reported in Table 4.Panel A shows that the correlations between NRPT and PMC(measured by Num,CR4 and HHI)are positive and significant at the 1%level.As expected,we find a positive correlation between NRPT and CashR,and NRPT is also positively correlated with PROS.The correlation analysis is consistent when we change the dependent variable NRPT into NPRT_Purc and NRPT_Sale.

4.4.Regression analysis

Table 5 reports the regression results for product market competition and normal related party transactions.As expected,the results in columns 1,3 and 5 reveal that product market competition has a statistically significant positive effect on normal RPTs.In column 2,we use two dummy variables instead of the variable Num.The coefficients(t-values)of Num_L and Num_H are-0.014(-3.86)and 0.057(18.98).The results in columns 4 and 6 are similar to the results in column 2.In summary,these results indicate that product market competition is significantly positively related to normal RPTs.

Table 6 reports regression results when we replace the dependent variable NRPT with NRPT_Purc and NRPT_Sale.The empirical results are consistent with those in Table 5,which suggests that the extent of related party purchases and related sales increases with the level of competition.For example,the coefficients (t-values)of Num,CR4 and HHI in columns(1)to(3)are 0.021(17.55),0.059(9.25)and 0.042(3.29),respec-

tively.In summary,the results provide evidence for Hypothesis 1,which states that product market competition is significantly positively related to normal RPTs.

We then examine the interaction effect of product market competition and the ultimate controlling shareholder's cash flow rights on normal RPTs.Panel A of Table 7 presents the results of estimating Eq.(3).The continuous variables Num,CR4 and HHI are used as the proxy variables for PMC in Panel A and the dummy variables are used in Panel B.The coefficients of CashR in columns(1)to(3)are 0.131,0.121 and 0.311, respectively.They are all statistically significant at the 1%level.Similar to the results in Table 5,the coefficients of Num,CR4 and HHI are significantly positive.The results show that both product market competition and the ultimate controlling shareholder's cash flow rights have significant positive effects on normal RPTs.The coefficients(t-values)of the interaction terms Num×CashR,CR4×CashR and HHI×CashR are-0.017(-1.59),-0.104(-1.89)and-0.279(-5.96),respectively.These results are consistent with Hypothesis 2,suggesting that the ultimate controlling shareholder's cash flow rights have more influence on normal RPTs in firms in noncompetitive industries than in firms in competitive industries.This implies that product market competition is a substitute for internal corporate governance mechanisms.The results of Panel B further suggest that this substitution only occurs at higher levels of competition.

In Table 8,we replace the dependent variable NRPT with NRPT_Purc and NRPT_Sale.Consistent with the results in Table 7,the coefficients of the interaction terms are generally significantly negative.

These results indicate that product market competition and the ultimate controlling shareholder's cash flow rights have an interaction effect on normal RPTs,with the ultimate controlling shareholder's cash flow rights in noncompetitive industries being more likely to increase normal RPTs.Our results are consistent with Karuna(2010)and Giroud and Mueller(2011)in that product market competition can act as a substitute for internal corporate governance mechanisms.

5.Conclusion

Based on a sample of A-share Chinese listed firms from 2004 to 2009,we examine the effect of product market competition and the ultimate controlling shareholder's cash flow rights on normal RPTs.Product market competition is not only pivotal in influencing corporate strategies,but can also be a substitute for internal governance mechanisms.

We adopt Jian and Wong's(2010)approach to estimate normal RPTs.Our empirical evidence shows that product market competition has a significant positive effect on normal RPTs.This implies that firms in competitive industries can increase normal RPTs to reduce transaction costs.Further investigation shows that product market competition and the ultimate controlling shareholder's cash flow rights have an interaction effect on normal RPTs,with the ultimate controlling shareholder's cash flow rights in noncompetitive industries being more likely to improve normal RPTs.This provides evidence that product market competition can act as a substitute for the ultimate controlling shareholder's cash flow rights on normal RPTs.

Acknowledgments

This paper is the result of research supported by the National Nature Science Foundation of China (71263034,70902004);Humanities and Social Science Project of the Ministry of Education of China (10XJC630003);and Program of Higher-level Talents at Inner Mongolia University,China(Z20100103). We acknowledge the executive editor and the anonymous reviewer for their useful comments and suggestions.

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E-mail address:chen_shenglan@126.com(S.Chen).