The Effects of Reputational Sanctions on Culpable Firms: Evidence from China's Stock Markets

Abstract

Reputational sanctions are widely used as a regulatory tool to curb corporate misconduct. However, existing literature on its workings and effectiveness is largely limited to developed economies. We thus examine the case of China, focusing on an important yet understudied form of reputational sanction there, namely public criticisms imposed on culpable firms by the two Chinese stock exchanges in Shanghai and Shenzhen. We construct a unique dataset of all public criticisms announced by the two Chinese stock exchanges from 2013 to 2018, and find significantly negative cumulative abnormal returns around the announcement date. Cross-sectional regression analysis finds that there are several factors affecting the short-term market reaction to public criticisms, including financing propensity, governance mechanism, and equity nature. However, further tests show that the significant negative market reaction to public criticism only appears in the firms relying on external financing and those not controlled by state ownership. Importantly, the market reaction is not significant in cases where the firm had already self-exposed misconduct before the announcement of public criticisms by the stock exchange. To have a more complete picture of the effectiveness of public criticism, our paper is the first of its kind to examine other effects of public criticism. We find that public criticism does not improve firms’ long-term values, nor produce strong deterrence to change their behaviour. Overall, the evidence of the effects of public criticism on culpable firms is mixed, suggesting that reputational sanction is a weak, if not ineffective, instrument of market regulation in China.