Corporate governance, connected transactions with insiders, and firms' returns : evidence from Hong Kong

Abstract

Using a sample of Hong Kong listed firms from January 2003 to December 2006, this thesis provides evidence wherefirms announcing connected transactions with executives, directors or substantial shareholders, not only controlling shareholders, are having fewer independent directors and smaller board size than arm's length transactions firms. The short term announcement effect of the connected transactions drives the stock price significantly lower than firms announcing arms length transactions. This could be explained by the expropriation hypothesis and inequality of power (opportunity) theory where executives, directors, substantial shareholders or controlling shareholdersare perceived to be taking advantage of minority shareholders in connected transactions. The discounting mechanism is going on to adjust the likelihood of deviance. As far as the environment is concerned, insiders seem to choose firms to conduct connected transaction wherefirms have significant higher level of assets and cash (to pay cash dividends). I also find that big four accounting firms are viewed by capital market to provide certain protection to minority shareholders in case connected transactions do happen in firms. In the long run (two to five years after announcement), the excess return of connected transactions firms way underperform the arms length transaction firms. Furthermore, I find evidence operating performance such as asset turnover of connected transactions firms are significantly deteriorated starting from three to five years after announcement. A good corporate governance system cannot be static and works for decades. Insiders could always find new ways to hurt minority shareholders if they choose to. This study suggests that current regulatory requirement on connected transactions in Hong Kong has room to improve where minority shareholders will be better protected on potential expropriation. For example, big four accounting firms could be made mandatory as external auditor for firms planning to conduct connected transactions. These accounting firms are more adept to detect and report unusual behavior among the insiders. The marginal benefit of this policy (less potential stealing) might outweigh the marginal cost of this requirement (regulatory costs, compliance costs).