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The value of relationship-based and market-based contracting: Evidence from corporate scandals in China

This paper compares the value of relationship-based and market-based contracting in China by examining the consequence of corporate scandals, defined as enforcement actions against firms or their managers by Chinese courts and securities regulators. Since contracts are primarily conducted based on political relationships rather than market mechanisms in China, we hypothesize that scandals such as bribery of government officials that sever firms’ political ties are more damaging than scandals such as misrepresentation of financial statements that hurt firms’ market credibility. To test this hypothesis, we categorize 212 Chinese corporate scandals from 1997-2005 by whether the scandal primarily damages i) the firm’s political networks and hence its ability to conduct relationship-based contracting (relationship scandals), ii) the firm’s market credibility and thus its ability to conduct market-based contracting (market scandals), or iii) both (mixed scandals). Consistent with our hypothesis, we find that the stock market reacts more negatively to relationship and mixed scandals than to market scandals, and this result holds with or without controlling for the magnitude of scandals, average stock price and earnings performance prior to the scandals, and legal penalties imposed on the firms and individuals. In addition, firms involved with relationship and mixed scandals experience worse stock returns when they rely more on political networks. We also find that, compared to market scandals, relationship and mixed scandals lead to greater departure of political and affiliated directors and larger decreases in loans from stateowned banks.