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Journal of Business Ethics

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04-12-2014

Executive Compensation and Corporate Fraud in China

Authors: Martin J. Conyon, Lerong He

Published in: Journal of Business Ethics | Issue 4/2016

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Abstract

This study investigates the relation between CEO compensation and corporate fraud in China. We document a significantly negative correlation between CEO compensation and corporate fraud using data on publicly traded firms between 2005 and 2010. Our findings are consistent with the hypothesis that firms penalize CEOs for fraud by lowering their pay. We also find that CEO compensation is lower in firms that commit more severe frauds. Panel data fixed effects and propensity score methods are used to demonstrate these effects. Our results also indicate that corporate governance mechanisms influence the magnitude of punishment. We find that CEOs of privately controlled firms, firms that split the posts of CEO and chairman, and CEOs of firms located in developed regions suffer larger compensation penalties for committing financial fraud. Finally, we show that CEOs at firms that commit fraud are more likely to be replaced compared to those at non-fraud firms.

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The information is translated by the author from original Chinese documents of these firms. Information on Beifang Chuangye Corp is obtained from

http://www.bfcy.cc/%28hyhvc1jpwgx1no45g0w2v145%29/UploadFile/2010511165428515.pdf. Information on Industrial Bank Corp. is downloaded from http://download.cib.com.cn/netbank/download/cn/Investor_Relations/20130917.pdf. Information on Sichuan Mingxing Electric Power Co. could be obtained from http://www.mxdl.com.cn/uploadfile/2013/2/18111137328.pdf.

Information on Great Wall Technology could be assessed from http://www.cec.com.cn. Information on Capital Environmental Protection could be assessed from ftp://www.tjcep.com/29aa37a4-ba25-45f2-9767-4946630877f8.pdf. Information on Copote is obtained from http://www.copote.com/pdf/zlgz/600476_2012_6.pdf.

Prior to this, only average data for the top management team are accessible. We discuss this in the sensitivity analysis section later in this paper.

The title “Chief Executive Officer” or “CEO” is not commonly used in the GTA dataset. In this study, we identify the CEO position by the title “General Manager” or “President.” This captures most CEOs. We also manually checked other titles such as “Administrative President,” “Executive President” in cases where current CEO compensation data were missing.

The firm might have been committing fraud for several years prior to this announcement.

The GTA provides information on “Date of violation” (Vltyear) to identify financial years affected by a specific fraud. For example, an entry may be “1998, 1999, 2000, 2002,” which suggests the fraud affects and involves all these financial years. We count the number of years listed in the entry to capture Serious Fraud. It is coded as 4 in the above-mentioned example. When there are multiple violations in a given year, the count is aggregated within the year.

The NERI index covers marketization level of four direct-controlled municipalities and twenty-seven provinces. The four direct-controlled municipalities are Beijing, Shanghai, Tianjin, and Chongqing. The 27 mainland provinces (excluding Taiwan, Hong Kong, and Macau) include Anhui, Fujian, Gansu, Guangdong, Guangxi, Guizhou, Hainan, Hebei, Heilongjiang, Henan, Hubei, Hunan, Jiangsu, Jiangxi, Jilin, Liaoning, Neimeng (Inner Mongolia), Ningxia, Qinghai, Sangxi, Shandong, Shanxi, Sichuan, Xizang (Tibet), Xinjiang, Yunnan, and Zhejiang.

The CSRC classifies Chinese industries into 22 categories: Agriculture and fishery; Mining; Manufacturing-food/beverage; Manufacturing-Textiles; Manufacturing-Furniture; Manufacturing-Paper/Printing; Manufacturing-Petroleum; Manufacturing-Electronic; Manufacturing-Metal/Non-metal; Manufacturing-Machines; Manufacturing-Pharmaceutical; Manufacturing-others; Electricity, water, and other energy manufacturing and supply; Construction; Transportation and logistics; Information technology; Wholesales and retails; Finance and insurance; Real estate; Service; Communication; and Others.

For example, the statistician does not typically observe CEO and management quality but these are nevertheless important determinants of executive pay. Their exclusion leads to an omitted variable bias problem that can be partially ameliorated by including firm fixed effects.

The restriction reduced the number of firms in the sample to 307 and the number of firm years to 1028.

Endogenous selection is potentially a serious problem especially as the number and frequency of firms committing fraud in the population of public enterprises are, in fact, low. Another solution to the problem is instrumental variables. However, the difficulty here is that it is problematic to find a legitimate theoretical instrument that is correlated with the propensity to commit fraud (the relevance criteria) and is also uncorrelated to executive compensation (the exclusion criteria). In consequence, any chosen instrument set might turn out to be theoretically somewhat arbitrary.

The results are not affected by this choice. For example, re-estimation using the logit method yields qualitatively similar results.

It is necessary for this exercise to construct a binary variable from the count variable.

We would like to thank an anonymous reviewer for this suggestion.

We also find this set of qualitative results held for the OLS estimates and propensity score estimates as well.

We would like to thank a referee for suggesting this point.

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Title: Executive Compensation and Corporate Fraud in China
Authors: Martin J. Conyon
Lerong He
Publication date: 04-12-2014
Publisher: Springer Netherlands
Published in: Journal of Business Ethics / Issue 4/2016
Print ISSN: 0167-4544
Electronic ISSN: 1573-0697
DOI: https://doi.org/10.1007/s10551-014-2390-6

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