The Value of Relationship-based and Market-based Contracting: Evidence from Corporate Scandals in China

This paper examines the economic consequences of corporate scandals in an emerging economy such as China where contracts are primarily conducted based on relationships rather than market mechanisms. The key feature of this study is that we categorize each corporate scandal by whether it damages a firm’s ability to conduct relationship-based contracting (relationship scandals), market-based contracting (market scandals), or both (mixed scandals). We find that the stock market reacts more negatively to relationship and mixed scandals than to market scandals. We also find that firms with greater reliance on political networks experience worse market reactions to the scandals. In addition, the worse market reaction is driven by the relationship and mixed scandals (but not the market scandals). Finally, consistent with the stock return results, we find that relationship and mixed scandals lead to greater turnover of directors and decreases in short-term financing than do market scandals.