Tunnelling, Fraudulent Financial Statements and Regulation Effects: Chinese Evidence

This study investigates the impact of regulatory intervention on tunneling through inter-corporate loans in Chinese fraudulent firms. We find fraudulent firms have significantly higher tunneling through inter-corporate loans than matching firms, and suggest that controlling shareholders are motivated to delay the recognition of the ensuing loss in the financial statements to make it more difficult for auditors to detect tunneling. In 2006, new CSRC regulation introduced responsibility by board chairman to resolve tunneling issues while the two Chinese stock exchanges initiated a ‘name and shame’ of tunneling individuals and amounts tunneled through public media. We find that tunneling balances in a sample of fraudulent firms reduce significantly after the announcement of this strict anti-tunneling regulation. Relative to a matched sample, fraudulent firms experienced improved operating performance and higher abnormal returns following the imposition of the new anti-tunneling regulations. We also find that informal institutions, such as social trust play an important role in mitigating tunneling. Overall, our results suggest the means by which Chinese regulatory mechanisms have been effective in protecting minority shareholders from expropriation by controlling shareholders.