Tunneling or Propping: Evidence from Connected Transactions in China

Abstract

Friedman, Johnson, and Mitton (2003) develop a model in which, in equilibrium, controlling shareholders may choose either tunneling from or propping up their listed company depending on the magnitude of an adverse shock and the magnitude of the private benefits of control. In this paper, we employ connected transaction data from China to test the implications of their model. We hypothesize that, when listed companies are financially healthy (in financial distress), their controlling shareholders are more likely to conduct connected transactions to tunnel (prop up) their listed companies and the market reacts unfavorably (favorably) to the announcement of these transactions. Our empirical findings strongly support our hypotheses. We also find that all of the transaction types in our sample can be used for tunneling or propping depending on different financial situations of the firms. Finally, political connection is negatively associated with the announcement effect. Overall, our analysis supports Friedman et al.’s (2003) model by furnishing clear evidence for propping and tunneling to occur in the same company but at different times.

Keywords: Connected transactions, Tunneling, Propping, Chinese listed firms

JEL Classification: G34, G32, G38