Donald P. Jacobs Scholar; Assistant Professor of Accounting & Information Management
What happens if you can’t trust the government to enforce a contract?
In most developed economies, companies can rely on a robust legal system to enforce financial and contract law. This reassures potential investors that any dispute can (at least in theory) be neutrally resolved via the legal system.
But in a country like China, financial laws are not consistently enforced. In such economies, how do firms establish their bona fides for investors from the outside world?
This question became the starting point for new research from Aaron Yoon, an assistant professor of accounting information and management at the Kellogg School.
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“In the U.S., if you have a contract, you know the government is going to be there to enforce it. But in countries like China, it is less clear,” he says.
Companies in China—as in U.S., Europe, and Japan—are required by law to issue public communications about their financial health: press releases, earnings calls, and management forecasts.
Ideally, this kind of public disclosure should help companies attract international investment by helping those investors make sound decisions about where to put their money.
Yet this does not seem to be happening in China. Previous researchexamining the role of public corporate communication by Chinese firms found that “it doesn’t build credibility” with international investors, Yoon says. China’s weak enforcement of financial regulation not only makes it difficult to enforce contracts, but it also means that companies have little incentive to be fully truthful in their public financial disclosures.
“If a Chinese company violates a public-disclosure rule, the cost is very low,” he explains. “So when this enforcement system is broken, there’s little incentive to provide good information to the market, and even if it’s provided, it is uncertain whether international investors will perceive it as credible.”
Based on his own career experience, Yoon had an idea of what might be happening. (Before becoming a professor, Yoon worked as an equities trader and analyst at Credit Suisse.) So he knew that brokers like Credit Suisse, Morgan Stanley and Goldman Sachs regularly hosted so-called “corporate access events”—essentially, private in-person meetings—between vetted, high-quality firms and their own top-shelf institutional investing clients. This led him to wonder if these global brokerage houses were hosting such meetings between select Chinese firms and large global institutional investors.
In other words, were the Chinese firms building their credibility as responsible partners by way of these meetings?
Because of his previous work experience, Yoon knew that he could collect the details about these meetings to use as the basis for his research.
After a meeting takes place, the broker circulates bullet-point summaries in the daily sales reports issued to clients in order to solicit more business. These reports are archived in paid financial databases like Thomson Reuters.
“That’s how I could capture which companies a broker, like Morgan Stanley or Goldman Sachs, would allow their investors to meet,” Yoon explains. (Yoon also contacted some brokers and investment firms directly to expand his corporate-access-event dataset.)
To determine whether Chinese companies were benefiting from these private meetings, Yoon took advantage of the Shanghai–Hong Kong Connect, which was a market liberalization pilot program in China in 2014: 568 firms were selected for eligibility and the government quadrupled the amount of foreign money that could be invested in those firms. Yoon searched for these 568 firms among the meeting attendees. (He searched for another 382 comparable firms that were not part of the pilot program as a control group.)
“In the U.S., if you have a contract, you know the government is going to be there to enforce it. But in countries like China, it is less clear.”
Yoon hypothesized that if the brokered private meetings were an effective way of signaling credibility, the Chinese firms in the pilot program would increase the number of these meetings without increasing the frequency of their public financial-disclosure efforts. Furthermore, he hypothesized that the firms that took this approach would indeed attract more foreign investment than firms that did not.
If firms eligible for increased foreign investment under the pilot program behaved no differently than ineligible firms—and if they saw no better investment outcomes—then this would suggest these meetings are not particularly effective at building credibility.
Yoon found that Chinese firms eligible for more foreign investment did increase the number of meetings compared to ineligible firms—and significantly so.
“Essentially, these companies quadrupled the number of private meetings brokered by investment banks,” Yoon says—but they didn’t increase their public disclosure efforts at the same time. “Foreign investors don’t really trust the public disclosure, but they do trust the private disclosure that happens in these meetings,” Yoon explains.
And Yoon found that these meetings had the intended result.
The more brokered meetings a Chinese firm had, the more foreign investment it received. In fact, Chinese firms received an average of 30 percent more foreign investment with each additional meeting.
Furthermore, the investment banks, which collected fees for setting up the meetings, weren’t merely acting as blind matchmakers. Instead, Yoon argues, they were truly vetting the Chinese firms first.
Fortuitously for Yoon’s analysis—if not so much for China’s actual economy—the 2014 pilot program was swiftly followed by a crash in which the Chinese stock market lost 40 percent of its value between July and December of 2015.
Yoon found that the firms that engaged in more meetings with international institutional investors that were brokered by reputable investment banks experienced much less stock-price volatility during the crisis. These firms also better retained their foreign investors, and even showed higher returns compared to other firms.
To Yoon, this indicates that the investment banks were authenticating the Chinese firms’ quality. (An alternate explanation—that by attracting foreign investment, these firms were better able to weather a downturn—is less compelling, Yoon explains, given that foreign institutional investors owned less than 2 percent of total shares in these firms.)
“In the wake of this big shock, the firms that engaged in these brokered meetings weathered the storm better, because they were better firms to begin with,” he says.
Yoon says that the implications of his findings go well beyond China.
“There are more than a 100 countries in the world with similar—or even weaker—enforcement regimes than China’s,” he says. “How do we go about investing in firms within those economies? How should emerging markets grow? I think that’s something that we need to be thinking about.”
Additionally, Yoon says his findings play into bigger-picture discussions of the role that investment banks play in the economy.
“It’s almost a philosophical question: Why do these Wall Street brokers continue to exist, when they’re being criticized all the time for being paid too much—especially in a market like the U.S. where everything is supposed to be reasonably efficient?” Yoon says.
The research indicates that global brokers may be fulfilling a crucial role in helping high-quality international firms and large institutional investors navigate a kind of “safe passage” to meet each other.
John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.
Yoon, Aaron. 2018. “Credibility of Disclosures in Weak Enforcement Institutions: Evidence from Shanghai–Hong Kong Connect.” Working paper.
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