Enforceability and the Effectiveness of Laws and Regulations
51 Pages Posted: 9 Oct 2017 Last revised: 14 Oct 2017
Date Written: October 1, 2017
Tunneling by corporate insiders poses a threat to the Chinese stock market. Controlling shareholders can divert assets from listed firms or coerce firms to serve as guarantors on questionable loans. A new rule, enacted in 2005, prohibits asset diversion for 'non-operational' purposes, and firms complying with this rule experience a reduction in related party transactions, an increase in investment and dividends, and better performance. Another contemporary rule, aimed to standardize practice of firms providing loan guarantees, has very little impact on firms. We attribute the differences in the design, implementation and effectiveness of the rules to different enforcement cost of the two types of tunneling activities. Relative to loan guarantees, it is much easier for a third party to determine (ex ante) whether a particular form of diversion destroys firm value, and recognize and verify (ex post) the losses to the firm resulted from the diversion. Our results highlight the importance of enforceability: laws and regulations that can be enforced at lower costs are more likely to succeed, especially in countries with underdeveloped formal institutions.
Keywords: Enforceability, controlling shareholder, tunneling, loan guarantee, asset diversion
JEL Classification: G30, G34, K42
Suggested Citation: Suggested Citation