CUHK Business School Research Reveals New Evidence of Conflicts of Interest among Financial Intermediaries and their Clients in China

CHINA - Media OutReach - 2
December 2019 - China's 2005 reform of its dual-class
share structure was said to have improved listed firms' corporate governance by
allowing companies' founding shareholders to convert previously restricted
stock into openly traded shares. Some academic studies suggested the changes
better aligned the interests of large shareholders and public investors.


However, a team of researchers,
including Prof. Donghui Wu,
Professor of School of Accountancy and Director of Centre for Institutions and
Governance at The Chinese University of Hong Kong (CUHK) Business School,
examined the problems created by the reform, which inadvertently led to a
bonanza for large shareholders.


"We wanted to look at the
potential conflicts of interest arising from large sales of shareholders'
previously restricted, non-tradable shares," says Prof. Wu.


"In particular, the reform
provides holders of the restricted shares an opportunity to cash-in their
equity investments on the open market after their conversion into tradable
shares," he says. "These shareholders have an incentive to maintain a
high stock price when planning the sale of their converted shares."


The study entitled "When is the client king? Evidence from affiliated-analyst
recommendations in China's split-share reform"
was carried out in collaboration with scholars from the Western Kentucky
University in the United States, and the Central University of Finance and
Economics, the Renmin University of China, and the Chongqing University in


The Evolution of China's Stock Market

Stimulated by the nation's
impressive economic growth, China's stock market overtook Japan as the world's
second-largest stock market in late 2009. The evolution of the country's stock
market saw the Chinese government set up its unique dual-class share structure
for listed firms in the early 1990s. To preserve state control over listed
firms, shares held by the founders -- typically the state or governmental
entities -- could not be traded publicly and were referred to as non-tradable


By the late 1990s, it was clear that
the dual-class share structure could induce severe corporate governance
problems and erode public confidence in the stock market, so the split-share
reform was introduced in 2005, allowing the founding, large shareholders to
convert non-tradable shares to tradable ones on stock exchanges.

The Study

In the study, the researchers hypothesized
that large shareholders enlist the help of analysts affiliated with
underwriting banks of their companies to provide optimistically biased stock
recommendations to increase the stock price before they sell the previously
non-tradable shares.


And they found that conflicts of
interest have led to affiliated analysts issuing recommendations to public
investors that are significantly stronger and more optimistic when firms' large
shareholders plan to sell their converted stock -- sparking inflated share


"Such optimism, however, is
associated with negative post-sale stock returns -- suggesting that large
shareholders profit from the converted share sales," Prof. Wu says.
"Meanwhile, public investors are misled and end up losing money."


The study collected data on 6,518
shares sales by large shareholders from January 2006 to December 2014, which
had a total market value of 625 billion yuan (about US$87 billion). Only 70
sales occurred in the first year, but the frequency increased quickly and peaked
in 2009, with 1,098 such events. The final study sample covers 1,523 sales -- 23
per cent of the total, but 37 per cent in terms of total market value.


Prof. Wu says the mean share sale
amount in the sample was 151.15 million yuan, so the substantial financial
gains to large shareholders, mostly institutional investors, would certainly be
a reason to hype share prices when liquidating equity.


Analyst recommendations are an important
information source for Chinese public investors. The Shenzhen Stock Exchange
reported in 2011 that a significant proportion of investors use analyst
recommendations in making their investment decisions. When planning to sell
their shares, large shareholders may approach brokerages with prior
underwriting connections for more favourable recommendations.


Overall, there were 8,988 analyst recommendations
made about the sales during the 90-day window before they took place. The
analysts used five different recommendation levels -- "strong buy",
"buy", "hold", "sell", and "strong sell"
-- representing their views about the stocks.


The study found that the odds of an affiliated
analyst issuing a more favourable rating -- for example from "buy" to
"strong buy" -- during the 90-day window before the sale of the
converted shares -- rose by 69 per cent compared with concurrent recommendations
of similarly affiliated analysts that are covering firms without such share


"Our analysis also shows that affiliated
analysts do not always curry favour with their prior clients; rather, they do
so when prior clients are likely to profit from inflated share prices,"
says Prof. Wu.


This result highlights the importance of
identifying the conditions under which conflict of interest by financial
intermediaries arises. "Otherwise, investors can anticipate and adjust for
affiliated analysts' bias. In such a case, clients cannot benefit and analysts
will not bias their research," he explains.


Another important condition for the conflict of
interest is the sizeable gains to prior clients.


"Analysts may not favour their prior clients
because issuing biased recommendations can harm their credibility and personal
reputation," says Prof. Wu, adding that the enormous financial benefits
can make large shareholders' commitments to returning favours more credible
such that analysts may sacrifice their reputations for the sake of future
business opportunities for their brokerages and benefits for themselves.


"Supporting this favour-exchange narrative, we
find that connected brokerages execute more sell trades for the large
shareholders and have a better chance of winning future lead-underwriter
appointments from the large shareholders' firms," he says.


Reflecting the economic significance, a
one-standard-deviation increase in analysts' recommendation ratings boosts the
odds of their employers winning the future underwriting business by 57.5 per


The researchers also observe the benefits to the
analysts themselves. After the sale of converted shares, the number of site
visits to covered firms by affiliated analysts is 35.8 per cent higher than
that of their rivals, the study reports. With better access to the company
management, the analysts are able to improve the quality of their research. On
average, the accuracy of their post-sale earnings forecasts increases by 78.3
per cent compared with their peers.


Thus, by improving the quality of their future
research, analysts can mitigate their reputation loss due to biased
recommendations. The researchers identify one possible mechanism for financial
analysts to trade off the costs and benefits of recommendation optimism.


"By showing a dynamic process of favour
exchanges, we provide new evidence of the mechanisms and conditions for
conflicts of interest among financial intermediaries and their clients,"
he says.


Prof. Wu says while large investors, analysts and
brokerages all gain from this collusive game, the study found uninformed
investors lose on average 5.5 per cent of the value of their investments over
the 90-day post-sale window by buying stocks covered by affiliated analysts.


Though the reform of dual-class share structure has
been generally regarded as a milestone in China's capital market development,
it has yielded an unintended consequence, as revealed by the study.


"The reform was aimed at addressing agency
conflicts as a result of the non-tradability of large shareholders' equity.
However, large shareholders can take advantage of their close ties to financial
intermediaries to reap benefits from share sales," says Prof. Wu.


The study findings hold important regulatory
implications, for instance, a requirement -- similar to the one that exists in
the US -- that demands analysts disclose potential conflicts of interest when
issuing research reports would be constructive.


To better protect the interests of public
investors, Prof. Wu believes strengthening disclosure requirement when large
shareholders intend to liquidate their equity would be helpful.


"For public investors, the takeaway message
from our study is that they must be cautious about listening to the advice of
analysts when large shareholders' plans to sell off their stock," he says.


Kam C. Chan, Xuanyu Jiang, Donghui Wu, Nianhang Xu
and Hong Zeng, When Is the Client
King? Evidence from Affiliated-Analyst Recommendations in China's Split-Share
Reform, Contemporary
Accounting Research


About CUHK Business School

Business School comprises two schools -- Accountancy and Hotel and
Tourism Management -- and four departments -- Decision Sciences and
Managerial Economics, Finance, Management and Marketing. Established
in Hong Kong in 1963, it is the first business school to offer BBA, MBA and
Executive MBA programmes in the region. Today, the School
offers 8 undergraduate programmes and 20
graduate programmes including MBA, EMBA,
Master, MSc, MPhil and Ph.D.


the Financial Times Global MBA Ranking 2019,
CUHK MBA is ranked 57th. In FT's 2019 EMBA ranking, CUHK EMBA is ranked 24th
in the world. CUHK Business School has the largest number of business alumni (36,000+)
among universities/business schools in Hong Kong -- many of whom are key
business leaders. The School currently has about 4,400
undergraduate and postgraduate students.


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