Corporate Performance Reference Points and Controlling Shareholder's Share Pledging: Motivations and Governance
JIANG Fuwei, CHEN Yiyao, DING Hui
Center for Macroeconomic Research/ School of Economics/ The Wang Yanan Institute for Studies in Economics, Xiamen University; School of Finance, Central University of Finance and Economics; School of Economics and Management, Beijing Jiaotong University
Summary:
Share pledging serves as a crucial financing method for controlling shareholders in China's listed companies. By pledging shares, controlling shareholders can obtain financing from financial institutions using their holdings as collateral. However, share pledging carries high-risk characteristics. If a company's stock price declines rapidly or the borrower fails to repay the loan upon maturity, the controlling shareholder may face the risk of forced liquidation of pledged shares, potentially leading to a loss of control. A sharp decline in stock prices can easily trigger discounted share sales and risk contagion, thereby evolving into systemic risks. Therefore, clarifying the economic motivations and governance mechanisms behind controlling shareholders' share pledging holds significant practical importance for preventing financial risks and promoting high-quality development of listed companies. We innovatively integrate prospect theory with the behavioral theory of firms to propose a corporate behavior framework that accounts for decision-maker heterogeneity. Since both prospect theory and the behavioral theory of firms originated in Western countries where corporate ownership structures are dispersed and management serves as key decision-makers, existing literature has primarily investigated reference point effects from a managerial perspective. However, China's corporate landscape features high ownership concentration, with controlling shareholders of listed companies often serving as de facto controllers, whose risk preferences may also be influenced by performance reference points. Theoretical analysis demonstrates that when corporate performance falls below the reference point, controlling shareholders operate in a loss domain, leading to increased risk appetite. This paper accordingly proposes that when corporate performance falls below the reference point, controlling shareholders exhibit enhanced risk-seeking tendencies, increasing the likelihood of engaging in high-risk financing through share pledging. This study selects A-share listed companies in China from 2000 to 2022 as its sample, using the median performance of firms in the same industry with identical ownership types as the reference point to empirically test the impact of corporate performance relative to this benchmark on controlling shareholders' share pledging. The findings indicate that when corporate performance falls below the reference point, both the probability and proportion of share pledging by controlling shareholders increase significantly. To alleviate endogeneity concerns, this paper employs regression discontinuity estimation, sample matching methods, and the exclusion of other reference.points, with the results remaining robust. In analyzing economic motivations, this paper categorizes pledging behaviors from the perspective of individual controlling shareholders into three types of motivations: first, investment motivation, where controlling shareholders use funds obtained from pledging to invest in other projects or financial markets with higher returns; second, tunneling motivation, where controlling shareholders use pledging to expropriate listed companies or transfer profits to safeguard personal gains; and third, propping motivation, where controlling shareholders use pledging to raise funds for listed companies to alleviate financing constraints. Empirical results demonstrate that when performance falls below the reference point, high pledge ratios are often associated with external investments or tunneling behaviors, while low pledge ratios more frequently reflect objectives supporting corporate development. Regarding the governance effects of external shareholders, both minority investor supervision and state capital participation suppress controlling shareholders' share pledging motivations, while institutional investors adopt a contingent approach, promoting propping motivations while inhibiting tunneling motivations. The main contributions of this paper are threefold: First, by integrating prospect theory with the behavioral theory of firms, it proposes a corporate behavior framework incorporating decision-maker heterogeneity, revealing changes in risk preferences of controlling shareholders as core decision-makers when performance deviates from reference points, thereby enriching the research paradigm of the behavioral theory of firms. Second, it identifies the economic motivations through which performance reference points influence share pledging and clarifies the relationship between share pledging ratios and different motivations, providing new insights for identification and categorized regulation. Third, it reveals the governance effects of external shareholders on share pledging, demonstrating that minority investor supervision and state capital participation suppress share pledging motivations, while institutional investors exercise contingent governance. These findings provide empirical evidence for improving the share pledging risk governance system in China. Overall, we find that corporate performance reference points serve as crucial psychological and behavioral benchmarks explaining controlling shareholders' share pledging behavior. When corporate performance falls below the reference point, controlling shareholders' risk preferences increase, leading them to favor financing through share pledging. Their behavioral motivations include investment motives, tunneling motives and propping motives. This paper provides policy implications for regulatory authorities to improve categorized regulation, strengthen external supervision, and prevent systemic risks.
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