When Is the Client King? Evidence from Affiliated-Analyst Recommendations in China’s Split-Share Reform

Abstract

China’s split-share reform of 2005 (the Reform) converts the previously restricted shares held by founding shareholders to shares tradable on the open market. Against this backdrop, we study how underwriter-affiliated analysts and firms’ large shareholders interact in the event of the latter’s sales of restricted shares. We document that recommendations made by affiliated analysts are significantly more optimistic when firms’ large shareholders plan to sell their restricted shares. This optimism, however, is associated with negative post-sale stock returns, suggesting that large shareholders profit from share sales but at the cost of public investors. Furthermore, large shareholders sell more restricted shares through the affiliated brokerages with analysts issuing more optimistic recommendations and firms under their control are more likely to appoint such brokerages as lead underwriters when they refinance in the future. For the affiliated analysts, they conduct more site visits to the firms after the share sales, thereby improving their earnings forecast accuracy. Our analysis shows how conflicts of interest by financial intermediaries arise following the Reform and leads to large shareholders’ extraction of rents from public investors. These findings have regulatory implications.