Ownership, independent directors, agency
costs and financial distress: evidence from
Chinese listed companies
Hong-xia Li, Zong-jun Wang and Xiao-lan Deng
Hong-xia Li and
Zong-jun Wang are both
based at the School of
Management, Huazhong
University of Science and
Technology, Wuhan, China.
Xiao-lan Deng is based at
the School of Management,
Fuzhou University, Fuzhou,
China.
Received: 23 January 2007
Revised: 18 September 2007
Accepted: 22 September 2007
PAGE 622 j CORPORATE GOVERNANCE
Abstract
Purpose – The purpose of this research is to examine the influence of ownership structure, independent
directors, managerial agency costs and audit’s opinion on the firm’s financially distressed status using a
sample of distressed companies and a matched-pair sample of non-distressed companies listed on
Chinese stock markets.
Design/methodology/approach – The study utilizes publicly-available data from annual reports of a
sample of 404 non-finance distressed firms listed on Chinese stock markets and a sample of matched
404 non-distressed firms for a period covering the 1998-2005 financial years with binary logistic
analysis.
Findings – Ownership concentration, state ownership, ultimate owner, independent directors and
auditors’ opinion turn out to be negatively associated with the probability of financial distress, while
administrative expense ratio is positively related with the likelihood of financial distress. Managerial
ownership does not appear to be a significant determinant.
Originality/value – The paper offers evidence on the extent to which distress is associated with
corporate governance from the emerging stock markets. It would be educational to Chinese small
investors who excessively favour pursuing short-term returns and be helpful for regulatory authorities in
making policies on corporate governance reformation.
Keywords Corporate governance, Corporate ownership, Directors
Paper type Research paper
Introduction
In today’s business environment, corporate governance has been increasingly the focus of
regulators, investors, lenders and other stakeholders throughout financial markets
worldwide. In fact, the Asian financial crisis was the result of not only a loss in investor
confidence but, more importantly, also a lack of effective corporate governance (Ho and
Wong, 2001).
However, most research on corporate governance has been conducted in mature market
economies of the West. The past decade has seen a surge of interest in formerly planned
economies such as Russia, Eastern European countries and more importantly China. Many
of the firms in these countries have adopted corporate structures that resemble western
business corporations, though with specific features inherited from a socialist background
(Nolan, 1996; Dyck, 1997; Huang and Song, 2005). Since these firms are operating in a
context that is different from a mature market economy, certain current findings about the
effectiveness of governance mechanisms may not apply (Hoskisson et al., 2000; Tian and
Lau, 2001; Wright et al., 2005).
In this paper, we focus on the impact of corporate governance on financial distress in the
context of China’s transitional economy, based on a context-sensitive approach (Whetten,
j VOL. 8 NO. 5 2008, pp. 622-636, Q Emerald Group Publishing Limited, ISSN 1472-0701 DOI 10.1108/14720700810913287
2002). Specifically, we develop a set of hypotheses generated in the Chinese context to
evaluate the influence of corporate governance characteristics on financial distress. This
issue is critical because most of the financial failure is caused by poor governance in China.
The primary contribution of this paper is to provide a valuable out-of-sample test of the
current literature which has mainly focused on the USA stock market. Second, the unique
legislation in China regarding the suspension and termination of listed loss making firms,
adds a new dimension to the current corporate governance literature. Another contribution is
that the definition of financial distress adopted by this study is different from the one used in
previous studies (e.g. Elloumi and Gueyié, 2001) where this study adopts the definition of
financial distress as used by the Chinese Securities Regulatory Commission (CSRC).

Corporate governance characteristics of listed companies in China

There are some distinguished characteristics of Chinese listed companies’ corporate
governance. A prominent characteristic is the separated and extremely uneven ownership
structure. Shares in Chinese listed companies are classified into two categories, namely,
tradable shares and non-tradable shares. The non-tradable shares take up a large
proportion of outstanding shares. In the end of 2005, the average non-tradable shares
account for nearly 60 percent of total shares[1]. On average, the top one and top five
shareholders own 40.31 percent and 57.49 percent of their company’s total shares
respectively, while top ten shareholders just own 60.49 percent of the company’s total
outstanding shares[1]. In nearly 33 percent of all the companies, the top one shareholder
controls above 50 percent of the total outstanding shares; in around 73 percent of all the
companies, the top five shareholders owns at least 50 percent of the companies’ total
shares[1]. The separated and uneven ownership structure may cause some problems, such
as large shareholders’ expropriation and lower independence of the board.
The second characteristic is that state shareholding incurs some principal-agency
problems. In the end of 2005, 77.91 percent of all the listed companies still retain residual
state ownership. The average percentage of state shareholding for all the companies is
34.51 percent[1]. For the state shares, the ultimate shareholder is the public of People’s
Republic of China. Although the government agencies hold the control rights of the state
shares, the dividends or gains distributed to these shares should be submitted to finance
departments. The government agencies cannot benefit from the improvement on corporate
governance and the companies’ performance. Additionally, the risk residual of the state
shares is ultimately born by the public or the state. Under these conditions, it is not surprising
that the state-owned companies would encounter inefficiency of monitoring mechanism and
moral hazard problem (Lin, 2001). Moreover, top managers are often selected beforehand
by the party organization and the government’s personnel department. The board then
rubber-stamps the appointment. Under these bureaucratic selection measures, the
managers of the state shareholding companies naturally pursuit political relationship with
government official rather than performance improvement.
The third character of corporate governance is insider controlling problem. There are some
factors causing this phenomenon. First, large proportion and excessive concentration of
non-tradable shareholdings impede the emergence of market for corporate control. The lack
of both hostile takeover and proxy contests facilitates management entrenchment. Second,
due to the widely dispersed tradable sharers, outside tradable shareholders have incentives
to take free ride. The insufficiency of monitoring from the outside shareholders tends to
engender the insiders’ discretion. Third, the appointment and evaluation of management are
often determined by the controlling shareholders, which may result in rent-seeking behaviors
and collusion between the controlling shareholders and management. Fourth, in Chinese
companies, managerial ownership is at extraordinarily low level. The average proportion of
ownership owned by management, directors and supervisors is 0.0225 percent in 2005[1].
Neither long-term equity-based nor performance-based compensation programs are widely
put into practice. The incentive alignment between the shareholders and management is
inadequate, which consequently invite some immoral and opportunist behaviors.

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VOL. 8 NO. 5 2008 CORPORATE GOVERNANCE PAGE 623
 Last but not least, the emerging market is lack of exit mechanism. The legislation on
Bankruptcy Law is lagging behind. Creditors’ rights and interests are not properly
safeguarded. There is even not a law applicable for the bankruptcy of listed companies. Up
to now, none of the listed companies has gone bankruptcy in China, though some of the
listed companies’ financial status is totally hopeless.
According to the above characteristics in Chinese companies’ corporate governance, so in
this paper, we attempt to answer the following questions:
1. Does the special ownership structure in Chinese listed companies have great influence
on the probability of financial distress?
2. Does independent director in Chinese listed companies operate well in reducing the
probability of financial distress?
3. Does agency cost problem exist and do harm to Chinese listed companies’ financial
status?
4. China’s auditing profession is relatively new and it has faced a steep learning curve, so
are certain audit firms more likely to deter financial distress?
In order to answer the above questions, in this paper, we just focus on the relationship
between ownership, independent directors, agency costs and financial distress with the
sample of Chinese listed companies, hoping to find useful results.

Methodology and sample selection

Sample selection
In this paper, we redefine financial distress companies as those suffered from ‘‘Special
Treatment (ST)’’ because of their financial abnormality in accordance with Deng and Wang
(2006) (detailed information can be seen in Chinese Securities Regulatory Commission
(CSRC), 1998), which is different from those used in the developed stock markets (detailed
definition of financial distress can be seen in Altman (1968)).
The sample in our study consists of companies that encounter financial distress since the
implementation of ST regulations in year 1998-2005, and in combination with their matching
companies. The sources of our data are derived from CCER. We collect data of these listed
companies one and two years before their ST announcement, respectively. By omitting
companies with some data unavailable, the final sample consists of 212 and 192 financial
distressed companies in year t-1 and t-2, respectively, matching with the same number of
healthy ones.

Methodology
We use binary logistic analysis to test the impact of corporate governance characteristics on
the risk of financial distress. The dependent variable equals one for distressed companies
and zero for healthy companies. The data are collected one and two years prior to the
occurrence of financial distress, respectively.

Proxies and hypothesis development

Ownership structure
Ownership concentration. Firms with concentrated ownership generally have large
shareholders that own a substantial amount of the stock. Such large shareholders have a
significant financial investment in the firm and are interested in increasing the value of their
holdings. Shareholders with a large number of shares can leverage their voting power and
impact strategic decision making (Hansen and Hill, 1991; Wright et al., 1996). Large
shareholders can monitor firm performance and management behavior in order to protect
their investment (Alchain and Demetz, 1972). It is also suggested that only large
shareholders have the economic rationalization to scrutinize management or firm

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PAGE 624 CORPORATE GOVERNANCE VOL. 8 NO. 5 2008
performance closely (Shleifer and Vishny, 1986). In addition, blockholders and large
shareholders are likely to support decisions that are shareholder-motivated (Holderness and
Sheehan, 1985; Mikkelson and Ruback, 1991). Thus, in firms with concentrated ownership,
shareholders are likely to have sufficient power to protect their interests and actively monitor
the firm’s performance. These shareholders can use their voting power to make necessary
changes more easily than the shareholders in widely-held firms.
What is more, concentrated-ownership firms are typically composed of active shareholders,
and the quality of monitoring is high. These add constraints that inhibit self-serving behavior
by management to improve performance. In such firms, managers may hesitate to adopt
self-serving, unprofitable strategies for fear of being discovered and the possible loss of
employment (James and Soref, 1981; Kroll et al., 1993). Thus, large shareholders help
increase the firm’s value by preventing managers from behaving opportunistically (Shleifer
and Vishny, 1986). For Chinese listed companies, Xu and Wang (1997) report that the
relationship between ownership concentration and firm’s performance is significantly
positive. Wu and Wu and Wu (2005) also draw the same conclusion with their empirical study
about Chinese listed companies.
Here we use two concentration ratios to measure ownership concentration: the largest
shareholders’ ownership ( percent) measured as the percentage of shares held by largest
shareholders and the Herfindahl index of ownership concentration calculated by the total
sum of squared fraction of shares held by every top ten shareholders.
Furthermore, based on the above arguments in the second section, we infer that in most
cases the companies are dominated by the largest shareholders because of their excessive
large shareholding (nearly 44 percent on average). As some studies suggest, the
counterweight power from other large shareholders can generate a mechanism to monitor
the controlling shareholder and mitigate their diversion (La Porta and Lopez-de-Silanes,
1999; Pagano and Roel, 1998; Bennedsen and Wolfenzon, 1998). To capture the restriction
on the largest shareholder, we use the percentage of shares held by the second largest
shareholders subtracted from the percentage of shares held by the largest shareholders as
the measure of ownership balancing degree, and propose that:
H1. Ownership concentration is negatively associated with financial distress status.

State ownership. Property rights and agency cost theory lay the foundation for most work in
this area about state ownership and firm performance, arguing that private ownership
should be more efficient than public ownership. Hart et al. (1997) and Shleifer (1998)
conclude that private ownership is preferable, especially given their finding that government
managers (agents) have poor incentives to reduce costs or improve quality. Boycko et al.
(1994, 1996a,b) argue that SOE inefficiency comes from their pursuit of the objectives of
politicians who control them, and argue for private ownership by outside shareholders as the
way to resolve this agency cost. Boardman and Vining (1989) demonstrate that private firms
are more efficient than public and mixed enterprises after controlling for market
environments, and Vining and Boardman (1992) show that mixed enterprises are more
profitable than SOEs, although they fall far short of private firms. Galal et al. (1994),
Megginson et al. (1994), Boubakri and Cosset (1998), D’Souza and Megginson (1999) and
Berger et al. (2007) show that financial and operating efficiency improves after ownership is
shifted from public to private hands. However, the evidence favoring private ownership is far
from conclusive. Meyer (1975), Neuberg (1977) and Bruggink (1982) show that state owned
enterprises are more efficient than privately owned firms.
Regarding Chinese listed companies, we conjecture that the principal-agency problem
related to the state shareholding leads to performance decline. Xu and Wang (1997), Wei
and Varela (2003) present the empirical results that the proportion of state shares is
negatively related to Chinese firms’ performance. However, the state shareholding
companies are often burdened with some public responsibilities, such as promoting
employment and retaining economic stability. As the adverse impacts of financial distress

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VOL. 8 NO. 5 2008 CORPORATE GOVERNANCE PAGE 625
 may impair the state shareholding companies’ public function, the government is unlikely to
disregard these companies undergoing distress. Some administrative control and political
intervention must be executed to hinder the problematic companies from getting into
distress. In addition, the managers of the state shareholding companies, who were
practically selected in a bureaucratic way, will struggle against the distress so as to protect
their political prospects. The ‘‘survival with poor performance’’ is not a peculiar phenomenon
among Chinese state-owned enterprises. In this context, we hypothesize that:
H2. State ownership is negatively related to the probability of financial distress.

Here we use two variables to denote state ownership: state ownership and ultimate owner.
State ownership ( percent) is measured as the percentage of shares owned by the state, and
ultimate owner, if the ultimate owner of the company’s largest shareholder is state owned, it
equals 0, 1 otherwise.
Managerial ownership. To compel management to pursue shareholder interests, agency
theory suggests that incentive mechanisms should be put in place. Such incentives should
also affect the directors themselves; as noted by Minow and Bingham (1995), ‘‘nothing
makes directors think like shareholders more than being shareholders’’ (p. 497). Thus,
directors should hold some amount of financial risk as shareholders, which give them an
incentive to act in the best interests of shareholders. If directors have shared ownership in
the corporation, the maximization of shareholder interest will be more effectively monitored
and fulfilled.
On the contrary, Fama and Jensen (1983) contend that when the managers control enough
ownership to dominate the board, they could expropriate from shareholders without having
to worry about the threat against their position and compensations. Stulz (1988)
demonstrates that the greater managerial ownership and the more voting rights controlled
by management, the less likely a hostile takeover occurs, which consequently strengthens
managerial entrenchment. Shleifer and Vishny (1989) also explain that the more proportion
of ownership owned by the manager, the less shareholders can press him to act in their
interests. Some empirical investigations also present discordant conclusions about
correlations between the managerial ownership and the risk of financial distress or
corporate failure (e.g., Teall, 1993; Simpson and Gleason, 1998; Parker et al., 2002; Wu and
Wu, 2005).
Chinese Corporate Law stipulates that the directors, supervisors and managers are
forbidden to transfer their shares during their incumbent periods. Thus, for the managerial
owners, it is not easy to exit prior to the event of financial distress. It is still unsure how
managerial ownership affects the financial distress. Managerial ownership is measured as
the percentage of shares held by managers, directors and supervisors. And we propose
that:
H3. There is association between managerial ownership and financial distress.

Independent directors
According to CSRC, the independent directors are not allowed to occupy any executive
positions in the listed company where they are engaged. Also they are not allowed to be
involved in any business or other relationships with the companies or the major shareholders
that will disturb them from acting independently or objectively. In addition, independent
directors are prohibited from directly or indirectly holding more than 1 percent of the listed
company’s total shares.
Agency theorists consider the independence from management as a crucial board
characteristic from the perspective of board’s monitoring role (Fama, 1980; Fama and
Jensen, 1983; Jensen, 1993). The independent directors assume the responsibilities of
monitoring and evaluation on management (Jensen and Meckling, 1976). Empirical results
of Elloumi and Gueyié (2001) indicate that boards of financially distressed firms have fewer

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PAGE 626 CORPORATE GOVERNANCE VOL. 8 NO. 5 2008
outside members. Krivogorsky (2006) finds a strong positive relation between the portion of
independent directors on the board and profitability ratios in continental Europe companies.
Since the independent directors present more or less a constraint power to the
management, here we hypothesize that:
H4. Independent directors are negatively related to financial distress.

Managerial agency costs

According to Jensen and Meckling’s (1976) agency theory, managerial agency costs
increase with the separation of ownership and control. Managers, as the agents of
shareholders, are inclined to waste the corporate resources to satisfy their exploitative
purposes. Here we measure agency costs by administrative expenses. In China’s GAAP
items, expenses include administrative, selling and financial expenses. Administrative
expenses cover managerial salaries, executive expenses, traveling expenses,
entertainment expenses, utilities, conference expenditure, welfare payments and other
expenditure occurring in organizing and managing corporate operation. It is common to
observe that, in Chinese companies, managers dissipate administrative expenses in
automobiles, banquet, traveling, luxury official facilities and even recreation. Thus,
administrative expenses can be regarded as a close proxy for perquisite consumption
and managerial discretion in allocating corporate resources. To control corporate size and
output, we standardize the administrative expenses by sales. Considering job perks cause
shrink in company resources and higher management discretion, to a large extent, suggests
greater agency conflicts (Singh and Davidson, 2003) as well as the insufficiency of
monitoring technology (Ang et al., 2000). So we hypothesize that:
H5. There is a positive relationship between managerial agency costs and the
likelihood of financial distress.

Audit result
The traditional financial audit provides the external user with some measure of confidence in
a firm’s financial statements. The lack of quality in financial reporting, including reliability,
transparency, and adequate disclosure, leads to instability, poor quality, and risk in
investment (Alba et al., 1998). Therefore, a robust audit process is fundamental to the
integrity of financial reporting which, in turn, is fundamental to confidence in the capital
market. Therefore, audit opinions are supposed to provide information concerning both
financial and managerial qualities of the firms. Thus, audit opinions might be used as one
indicator of the possibility of the distress of the firms. The receipt of other than unqualified
audit opinions appears to be associated with a negative side of a firm’s status.
Empirically, various studies have examined the explanatory power of audit opinions.
Typically evidence supports a relationship between audit opinions and event of financial
distress. For example, Altman and McGough (1974) and Menon and Schwartz (1986) find
that about 50 percent of their samples received a going-concern qualification opinion before
the distress really occurred. Flagg et al. (1993) find positive relationship between
going-concern qualification opinion and the distress event. They also report the relationship
between the dividend status and four traditional financial ratios, and the financial distress
event. Similarly, Chen and Church (1992; 1996) provide evidence supporting the information
value of going-concern opinions.
As for Chinese stock markets, Wu and Wu (2005) indicate that companies with negative
standard audit result will increase the probability of companies running into significant
financial deterioration situation. As for this paper, we deem that audit reports, released
according to continuance operating principle, disclose the existence and hidden risk during
the operating process, thus it might be helpful to assess the financial distress situation
accurately. So we hypothesize that:
H6. Audit result is negatively related with the likelihood of financial distress.

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VOL. 8 NO. 5 2008 CORPORATE GOVERNANCE PAGE 627
 We make use of auditors’ opinion as proxy for audit result, equals 1 for standard
non-reserved result, 0 for otherwise.

Test of hypothesis
We use the following logistic regression models to test the hypothesized relationships:

Logit P i ¼ a0 þ a1 Financial leveragei þ a2 Liquidityi þ a3 Sales margini

þ a4 Governance characteristici þ 1i

where P i ¼ p (Distressi ¼ 1) is the estimated probability of financial distress for the ith
company. Governance characteristici is one of governance variables described above for
the ith company. Financial leverage, liquidity and sales margin are used as control variables.
Financial leverage is the ratio of total liabilities to total assets, and liquidity is the ratio of
current assets to current liabilities. They are used to control firm’s financial conditions. And
sales margin, ratio of net profits to sales revenue, is used to control company’s profitability.

Results and discussions

Summary statistics and univariate test

Table I presents the summary statistics and paired-sample t tests for the independent
variables in year t-1 and t-2, respectively.
As for t-1 year, the results indicate that the largest shareholders in distressed companies
hold significantly lower ownership than that in the matching companies, and Herfindahl
index of ownership concentration is much higher in healthy companies as compared with
distressed ones. Moreover, the distressed companies have a higher ownership balancing
degree. We also found that the state ownership (percent) of crisis companies is significantly
lower than that of healthy companies, while mean of ultimate owner of healthy companies is
much lower than that in distressed companies. It is striking that there are significantly far
higher managerial agency costs for financially distressed companies. On average, the
administrative expense ratio for healthy companies is only 16.35 percent, compared with
116.69 percent for distressed ones. To auditors’ opinion, there is also significant difference
between two groups. Significant mean differences are also found in variables of financial
leverage, current ratio and sales margin.
On the contrary, there is no difference in managerial ownership (percent) and independent
directors between two groups.
While in t-2 year, the results show that there are significant mean differences between two
groups on the largest shareholders’ ownership, Herfindahl index of ownership
concentration, ownership balancing degree, state ownership (percent), managerial
ownership ( percent), ultimate owner, independent directors, administrative expenses
ratio (percent), auditors’ opinion, current ratio and sales margin. While financial leverage,
there is no difference between the two groups.

Logistic analysis results

Tables II and III report the results of binary logistic regressions in year t-1 and t-2,
respectively. Results in Table II support hypothesis H1, H5 and H6; Table III supports H1, H2,
H4, H5 and H6.

Discussions

Ownership structure
The large shareholders’ ownership (percent) is negatively related with the probability of
financial distress in year t-1 and t-2, while the Herfindahl index of ownership concentration is
just negatively related with the probability of financial distress in year t-1. We conclude that
large shareholders might have incentives to monitor management and prevent financial

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PAGE 628 CORPORATE GOVERNANCE VOL. 8 NO. 5 2008
 Table I Descriptive statistics and paired-sample t-tests
t-1 year (n ¼ 424) t-2 year (n ¼ 384)
Variables Mean SD t-test* Mean SD t-test*

Control variables Financial leverage (%) 4.753 (0.000)*** 1.108 (0.269)

Distressed 1.1265 5.4442 1.3938 7.9009
Healthy 0.8297 5.7965 0.8976 6.4932
Total 0.9781 5.6179 1.1456 7.2251
Current ratio 22.384 (0.018)* 23.241 (0.001)***
Distressed 1.2194 3.3428 1.3807 0.9360
Healthy 1.8447 0.2625 2.3749 3.9050
Total 1.5321 2.6261 1.8778 2.8787
Sales margin 26.061 (0.000)*** 25.576 (0.000)***
Distressed 21.9763 4.8358 20.3344 0.9334
Healthy 0.1286 1.2296 0.0751 0.2540
Total 20.8462 3.3235 20.1296 0.4014
Ownership structure The largest shareholders’ ownership (%) 23.064 (0.002)*** 22.646 (0.009)***
Distressed 0.3803 0.1669 0.3998 0.1656
Healthy 0.4284 0.1651 0.4451 0.1637
Total 0.4049 0.1677 0.4224 0.1660
Herfindahl index of ownership concentration 22.928 (0.004)*** 21.975 (0.050)**
Distressed 0.1986 0.1476 0.2168 0.1693
Healthy 0.2432 0.1743 0.2519 0.1724
Total 0.2209 0.1628 0.2343 0.1716
Ownership balancing degree 22.747 (0.007)*** 22.230 (0.027)**
Distressed 0.2831 0.2159 0.3113 0.2144
Healthy 0.3419 0.2201 0.3629 0.2186
Total 0.3125 0.2197 0.3371 0.2177
State ownership (%) 22.589 (0.010)*** 22.766 (0.006)***
Distressed 26.1984 25.0164 28.0469 24.9864
Healthy 32.3 25.242 34.87 24.774
Total 29.2514 25.2831 31.4569 25.0774
Managerial ownership (%) 21.528 (0.128) 21.679 (0.095)*
Distressed 0.00068 0.00015 0.0007 0.0001
Healthy 0.00279 0.0255 0.0012 0.0084
Total 0.0014 0.0177 0.0006 0.0059
Ultimate owner 2.644 (0.009)*** 1.911 (0.058)*
Distressed 0.34 0.473 0.26 0.438
Healthy 0.23 0.421 0.18 0.386
Total 0.28 0.45 0.22 0.414
Independent directors Independent directors (%) 21.430 (0.154) 21.847 (0.066)*
Distressed 0.1807 0.1352 0.0930 0.1227
Healthy 0.1893 0.1407 0.1040 0.1318

j
Total 0.1853 0.1379 0.0986 0.1274
Managerial agency costs Administrative expense ratio (%) 5.005 (0.000)*** 4.025 (0.000)***
Distressed 1.1669 2.7151 0.3085 0.6054
Healthy 0.1635 0.7009 0.1162 0.1708
Total 0.6652 2.043 0.2123 0.4545
Audit result Auditors’opinion 211.889 (0.000)*** 26.541 (0.000)***
Distressed 0.47 0.5000 0.72 0.451
Healthy 0.94 0.231 0.96 0.199
Total 0.71 0.456 0.84 0.369

j
Notes: *** Significant at the 1% level; ** significant at the 5% level; * significant at the 10% level
Source: China Center for Economics Research (CCER) database

VOL. 8 NO. 5 2008 CORPORATE GOVERNANCE PAGE 629

j
Table II Logistic model regression results for all samples in year t2 1(n ¼ 424)
The
Independent expected

j
variables sign (1) (2) (3) (4) (5) (6) (7) (8) (9)

Intercept 2 3.368*** 23.723*** 2 3.546*** 2 3.723*** 2 3.791*** 2 4.013*** 2 3.794*** 2 4.338*** 2 1.712***
(1) The largest 2
shareholders’
ownership (%) 2 1.308 (0.068)*

PAGE 630 CORPORATE GOVERNANCE VOL. 8 NO. 5 2008

(2) Herfindahl 2
index of
ownership
concentration 21.196* (0.096)
(3) Ownership 2
balancing degree 2 1.170 (0.031)**
(4) State 2
ownership (%) 2 0.007 (0.138)
(5) Managerial ?
ownership (%) 2 1159.645 (0.105)
(6) Ultimate owner 2 0.291 (0.271)
(7) Independent 2
directors (%) 2 0.954 (0.265)
(8) Administrative þ
expense ratio (%) 2.173 (0.000)***
(9) Auditors’ _
opinion 2 2.243 (0.000)***
Financial leverage þ
(%) 7.069*** 7.178*** 7.091*** 7.109*** 7.043*** 7.109*** 7.162*** 6.755*** 6.319***
Current ratio 2 0.147** 0.172*** 0.146** 0.150** 0.0.157** 0.155** 0.146** 0.123** 0.126**
Sales margin _ 0.000* 0.000** 0.000 0.000 0.000* 0.000 0.000 0.000 0.000
Nagelkerke-R 2 0.410 0.409 0.413 0.407 0.413 0.405 0.406 0.502 0.510
LR chi-square test 154.461*** 153.907*** 155.801*** 153.316*** 156.100*** 152.324*** 151.473*** 198.658*** 202.532***
Classification ratio
performance (%) 73.2 74.3 72.4 74.1 73.9 75.1 74.3 81.7 79.3

Notes: The Wald Chi-square statistic is in the parentheses; * significant at the 10% level; ** significant at the 5% level; *** significant at the 1% level
Source: China Center for Economics Research (CCER) database
 Table III Logistic model regression results for all samples in year t22 (n ¼ 384)
The
Independent expected
variables sign (1) (2) (3) (4) (5) (6) (7) (8) (9)

Intercept 2 0.658 2 1.143** 2 0.863* 2 1.120** 2 1.472*** 2 1.604*** 2 1.381*** 2 1.855*** 0.665
(1) The largest 2
shareholders’
ownership (%) 2 1.602 (0.022)**
(2) Herfindahl 2
index of
ownership
concentration 2 1.095 (0.110)
(3) Ownership _
balancing degree 2 1.354 (0.011)**
(4) State _
ownership (%) 2 0.010 (0.033)**
(5) Managerial ?
ownership (%) 10.378 (0.330)
(6) Ultimate owner _ 2 0.892 (0.002)***
(7) Independent _
directors (%) 2 1.440 (0.100)*
(8) Administrative þ
expense ratio (%) 3.556 (0.000)***
(9) Auditors’ _
opinion 2 1.999 (0.000)***
Financial leverage þ
(%) 3.307*** 3.426*** 3.275*** 3.471*** 3.549*** 3.388*** 3.602*** 3.506*** 2.922***
Current ratio _ 2 0.074 2 0.068 2 0.079 2 0.065 2 0.067 2 0.065 2 0.066 2 0.110* 2 0.103*
Sales margin _ 2 2.396*** 2 2.339*** 2 2.450*** 2 2.319*** 2 2.374*** 2 2.562*** 2 2.532*** 2 1.470*** 2 2.133***
Model summary
Nagelkerke-R 2 0.289 0.282 0.293 0.288 0.277 0.303 0.295 0.314 0.344
LR chi-square test 92.881*** 90.218*** 94.181*** 92.177*** 88.488*** 97.859*** 93.715*** 101.975*** 113.323***
Classification ratio

j
performance (%) 72.7 73.0 74.8 74.3 73.8 75.6 73.7 73.2 76.9

Notes: The Wald Chi-square statistic is in the parentheses; * significant at the 10% level; ** significant at the 5% level; *** Significant at the 1% level
Source: China Center for Economics Research (CCER) database

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VOL. 8 NO. 5 2008 CORPORATE GOVERNANCE PAGE 631
 troubles. What is more, the regression coefficient for the ownership balancing degree is
significant in year t-1 and t-2, indicating that the counterweight power from other large
shareholders against the largest shareholders might act strongly thus reducing the
likelihood of financial distress.
As expected, state ownership ( percent) and ultimate owner are negative and significant in
year t-2. From this finding, it can be seen that the government and the management of the
state shareholding companies might make efforts to resist failure, although state ownership
may incur a series of principal-agency problems, possibly leading to managerial inefficiency
(Xu and Wang, 1997). Government tries to ‘‘rescue’’ the problematic state-shareholding
companies as possible as it can, for the state-shareholding companies are usually obliged
to bear some public functions. The managers of the state-shareholding companies also
have incentives to take precaution against distress in order to shield their acquired interests
and positions from risk.
Managerial ownership variable is insignificant. One possible explanation is that due to the
extremely small fraction of managerial ownership (as shown in Table I, the mean of
managerial ownership are 0.068 percent and 0.07 percent in year t-1 and t-2, respectively,
for financially distressed companies; 0.279 percent and 0.12 percent in year t-1 and
t-2,respectively, for health ones), the effects of convergence or entrenchment are
extraordinarily limited. Another possible reason could be that some of the shares held by
management belong to the employee shares which are issued with the purpose of providing
benefits rather than an incentive scheme (Xu and Wang, 1997).

Independent directors
The impact of independent directors (percent) differs between the crisis companies and the
matching sample in year t-2. Companies with higher proportion of independent directors are
less likely to encounter financial distress. This evidence is consistent with the ‘‘monitor and
control’’ arguments, suggesting that the independent directors could provide meaningful
counterweight and constraint power to the management.

Managerial agency costs

Administrative expense ratio (percent) is negatively related to companies’ financial status in
year t-1 and t-2. It suggests that deep agency conflicts and slack in monitoring reflected as
high level of administrative expenses could increase the danger of financial trouble in
Chinese listed companies.

Audit result
Auditors’ opinion, as our expected, is negatively related to companies’ financial status in
year t-1 and t-2, implying that audit committee might be a useful external regulation
mechanism in reducing the possibility of financial distress.

Control variables
Turning to accounting indicators, the results suggest that companies with higher leverage
are more likely to get into financial distress. It is inconclusive that whether current ratio
contributes to the financial distress. Our results also show that higher sales margin signals
lower likelihood of financial distress.

Summary
As reported in Tables II and III, the logistic regression models in year t-1 and t-2 are overall
significant. The state ownership (percent), administrative expense ratio and auditors’
opinions contribute to a relatively high correct classification ratio.

Conclusions
Few studies so far have explored the relation between corporate governance characteristics
and China’s corporate financial distress. This paper is one of the efforts trying to investigate

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PAGE 632 CORPORATE GOVERNANCE VOL. 8 NO. 5 2008
whether some governance characteristics contribute to explain the occurrence of financial
distress, in the context of Chinese transitional economy.
Our results suggest that the large shareholders’ ownership and the state ownership have
negative effects on the probability of distress. Managerial ownership appears to be
unrelated with the distress status. A higher proportion of the independent directors may lead
to lower probability of financial distress.
Specially, we investigate the impact of managerial agency costs and auditors’ opinion on the
risk of financial distress. The administrative expense ratio, as the measure of managerial
agency costs, turns out to be positively associated with the probability of financial distress,
implying that the managerial agency problems do harm to corporate financial condition.
While auditors’ opinion is proved to be negatively related to the likelihood of financial
distress, indicating that audit committee might be a valuable external governance
mechanism.
As the corporate governance reformations are vigorously advocated in China, our study
provides insights into the roles of corporate governance in financial healthiness. However,
although we have got some interesting findings, they are all based on Chinese stock
markets, so there are maybe limitations in extending to other countries. What is more, we do
not check the influence about year in corporate governance and financial distress, which
might be a useful indicator in distinguishing failure. What is more, the large shareholders in
Chinese listed companies impropriate the companies’ funds by diverse tunneling
techniques. In many cases, they conduct related party transactions at an unfair price to
the listed companies. They also frequently hold companies’ assets in pledge for loans.
Further research can be devoted in the effect of their expropriation behaviors on corporate
financial distress.

Note
1. The figures of shareholdings in this section are collected and calculated with the data from China
Center for Economics Research (CCER) Database.

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Corresponding authors
Hong-xia Li can be contacted at: lea_128@163.com; Xiao-lan Deng can be contacted at:
smilea@hotmail.com

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