The Contagion Effects of Irregularities within Business Groups
LIU Lihua,XU Yanping,RAO Pingui,CHEN Yue
School of Economics, Huazhong University of Science and Technology; Management School, Jinan University; School of Accountancy,Central University of Finance and Economics
Summary: Summary: Group-affiliated companies are linked in various formal and informal ways. At the same time, with the acceleration of company diversification, the organizational structure of business groups has gradually developed into a network structure including vertical and horizontal relationships. The literature has extensively explored the advantages and disadvantages of business groups from the perspective of operating efficiency and firm value (Bertrand et al., 2002). However, limited attention has been paid to the economic consequences of the network structure among group-affiliated companies. This study examines the contagion effect of an irregularities announcement among group-affiliated companies in the capital market. First, companies in the same business group have similar organizational structure and corporate governance characteristics. As studies have shown that irregularities are related to organizational structure and weak corporate governance, an irregularity in one group-affiliated company may indicate a greater likelihood of irregular behavior among other companies in the group. In addition, group-affiliated companies are connected through various ties (i.e., related party transactions, common personnel relations, and the establishment of financial companies). These ties provide group-affiliated companies with more channels through which to learn from and imitate each other, increasing the likelihood of a contagion effect within the group. Finally, an irregularities announcement provides new information to the market, based on which investors update their valuation of the other listed companies within the same business group (Chen and Goh, 2010). Therefore, when one group-affiliated company announces an irregularity event, investors reassess the reliability of the corporate governance and accounting performance of other companies in the same group, causing a contagion effect. Using the data of firms listed on the Shanghai and Shenzhen Stock Exchanges from 2003 to 2015, we find that: (1) a company's irregularity announcement can result in investor reassessment of other companies in the group and a significant decline in their stock prices. However, the contagion effect exists only when the irregularity relates to fraudulent financial reporting. (2) Further channel tests of the contagion effect show that the low earning quality of contagion firms and the existence of financial companies within the group can explain the decline in the stock prices. (3) Cross-sectional tests indicate that a company's internal and external governance can affect the contagion effect. Specifically, we find that contagion effects are stronger for state-owned enterprises and for companies operating in less-developed areas, covered by fewer analysts, and with higher ownership concentration. By studying the contagion effect of irregularities announcements within group-affiliated companies, our study makes three contributions. First, it provides richer and more robust evidence to better understand the organizational structure of business groups in emerging markets. The existing literature focuses on the contagion effect of performance or risk within a business group, and finds that the channel basically originates from related-party transactions, guarantees, and debt relationships among group-affiliated companies. In contrast, the irregularities data in this study is taken from the public disclosures of regulatory agencies such as the China Securities Regulatory Commission, the Ministry of Finance, and the exchange, thus our setting is more exogenous. Further, we use event study method to better identify causality and eliminate the influence of other factors. In the mechanism test, we find that the contagion effect within the group exists even with no related-party transaction or guarantee relationship, thus extending the prior literature. Second, this paper adds to the growing body of literature on the economic consequences of irregularities. Most existing studies only consider the impact of economic consequences for the irregularity company, while a few discuss the externalities of the irregularities announcement by listed companies through the joint auditors, the same industry, and the same region (Gleason et al., 2008; Beatty et al., 2013; Gul et al., 2018). On the other hand, Khanna and Rivkin (2001) suggest that the existing research ignores the influence of business group factors on firm behavior. Our study shows that irregularities have externalities within a business group, indicating that the overall negative impact of irregularities on the market is greater than that on the irregularity companies themselves as documented in prior studies. This further indicates a need to increase the supervision of irregularities. Finally, the results of our study are expected to provide a corresponding explanation for stock price synchronicity in emerging markets. Exisiting studies have shown that stock price synchronicity is significantly higher in China (Morck et al., 2000), which relates to China's institutional background. Our study shows that the contagion effect of irregularities within a business group may provide a new explanation for China's higher stock price synchronicity.
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